vy RESERVE BANK OF AUSTRALIA

Speech
Inflation Expectations - Why They Matter and
How They Are Formed

Sarah Hunter !*!

Assistant Governor (Economic)

Citi Australia and New Zealand Investment Conference
Sydney - 16 October 2024

Introduction

I would first like to pay respect to the traditional and original owners of this land, the Gadigal people
of the Eora Nation, to pay respect to those who have passed before us and to acknowledge today's

custodians of this land. I also extend that respect to any First Nations people joining us here today.

A low and stable inflation rate is critical to preserving macroeconomic stability. Having a good idea of
what's going to happen to prices allows businesses to plan for investment and expansion. It also
makes things like budgeting and financial planning easier for households. This is particularly true for
those on low incomes, who typically have smaller financial buffers than others and spend more of
their income on essentials. 1] And with more stable household and business balance sheets, the

financial system is more stable, !7]

The experience of the last few years has clearly highlighted this. Everyone across the economy has
felt the increased cost of living. {31 This is very clear in the data we monitor, such as household
spending, but it's perhaps more apparent in survey metrics such as consumer confidence, which
remains much lower than its pre-pandemic average (Graph 1). So there are a number of good

reasons to bring inflation down and keep it at a low and stable rate.

Graph 1

Consumer Sentiment*
Average since 1980 = 100
index index

120 120

100 a 'an b I 100

80 80

6guee_L Ltt ttt ttt ttt oto eg
1989 1996 2003 2010 2017 2024

* Mean of Westpac-Melbourne Institute and ANZ-Roy Morgan surveys;
ANZ--Roy Morgan index rescaled to have the same average as the
Westpac-Melbourne Institute index since 1996.

Sources: ANZ-Roy Morgan; RBA; Westpac-Melbourne Institute.

In addition to the tangible impact of elevated inflation today, central bankers often note that they
want to make sure that inflation expectations remain anchored. But why is this the case? And what

impact do current inflation outcomes have on expectations?

Why do inflation expectations matter?

Macroeconomists generally think that a prerequisite for consistently achieving low and stable inflation
over time is well-anchored inflation expectations. That is, people across the economy believe inflation
will generally average a low rate (in Australia's case, 2-3 per cent), and they make decisions based
on this underlying belief that becomes self-reinforcing. Indeed, this is a key lesson from economic
history; there are multiple episodes that demonstrate the damage de-anchored expectations can
cause, and the policy effort and welfare costs associated with re-anchoring them. Tiirkiye's current

experience is just one example (Graph 2). !41

Graph 2
Turkiye - Inflation and Policy Rate

% %

80 80
Inflation

60 60

40 40

Policy rate

20 20

0 L L ! L L 0
2014 2016 2018 2020 2022 2024
Sources: LSEG; RBA.

So why do expectations matter at all when it comes to economic outcomes? We think they matter
because people don't just make decisions based on what is happening today, they also factor in what
they think will happen tomorrow. In other words, inflation expectations are at least partly self-

fulfilling.

For example, our decision over how much to save for retirement today is determined by how much
income we think we'll need once we stop working, and this is partly influenced by what we think will

happen to prices between now and then.

In addition to changing the behaviour of households, inflation expectations also directly feed into all
of the decisions firms make - for example, over capital investment, pricing and staffing. One way this
occurs is through the wage-setting process (Graph 3).!°! This could be workers, or their union
representatives, bargaining for higher wages if they think inflation will be higher. ©! Or it could be
firms' expectations of higher future prices giving them the confidence to offer higher wages today to

attract workers.

Graph 3
Earnings Growth and Inflation

Year-ended
% %
25 25
20 20
Average weekly earnings*

15 15
10 10
5 5
0 0
5 eee ee ee Oe oe eee a!
1944 1964 1984 2004 2024

* - Data up to June quarter 1995 include males only due to data availability.
Sources: ABS; RBA.

And given that this is an investment conference, I'd be remiss not to mention how important inflation
expectations are to the domestic and international portfolio allocation decisions made by financial
market participants. These expectations then feed into long-term interest rates, exchange rates, and
the prices of assets in our superannuation funds and all other investment portfolios. In short, inflation

expectations are a factor in pretty much every economic decision that's made every day.

The fact that expectations feed into actual inflation outcomes means de-anchored expectations
typically leads to greater inflation volatility (Graph 4). Volatility breeds uncertainty, and uncertainty
makes decisions harder for everyone. As a business, how do you decide when it's right to invest if
you're less sure of the financial returns? And to go back to the example of households deciding how
much to save for retirement or to buy a home, a bout of unexpectedly high inflation is very hard to
plan for. Both the effort required to make decisions with uncertainty, and that some otherwise good

decisions will not be made, makes us all worse off.

Graph 4

Inflation Volatility
Year-ended CPI inflation

% . . ppt
Inflation targeting
---j7»
Inflation
20 (LHS) 6
10 4
0 2
Volatility*
(RHS)
-10 POPPE 0
1944 1964 1984 2004 2024

* - Standard deviation of year-ended CPI inflation over previous 10 years.
Sources: ABS; RBA.

Tracking inflation expectations

Given the enormous damage that such de-anchoring can cause, and that policy can be enacted more
flexibly while expectations remain anchored, the RBA Board is constantly alert for signs that this risk
might emerge here in Australia. '7! It does that by tracking a range of inflation expectations
measures, including multiple financial market measures, and surveys of households, unions and
professional forecasters. !8! That analysis indicates that inflation expectations have not become de-

anchored through the current high-inflation experience (Graph 5). !9!

Graph 5

Long-term Inflation Expectations
Average over the five years starting from five years ahead
% %

3.5 3.5
Professional forecasters*

3.0 3.0

2.5 2.5

Adjusted bond
market measure**
2.0 Poy t tt tp te fp ft tt tt

0
1994 1999 2004 2009 2014 2019 2024

* - Average of responses from a survey conducted by Consensus
Economics.

** Bond market measures of expectations can be affected by changes
in risk; here, we have extracted the estimated risk component.

Sources: Consensus Economics; Hambur and Finlay (2018); RBA.

So we're not currently concerned that expectations could become de-anchored in the near term. But
we do think it's important that we track how they're evolving and that we understand how
expectations are formed, so we can monitor whether there are any signs of this risk materialising in

the future.

As I've already alluded to, there are a number of different groups across the economy, and each
plays a part in determining aggregate macroeconomic outcomes. To understand what's happening to
expectations, we therefore need to understand how different groups form their inflation expectations,

as they each play critical roles in determining how the economy evolves over time.

For consumption/savings decisions, households' own expectations matter the most. For wage
bargaining and competition for labour, unions' and firms' expectations likely matter most. And when it
comes to how inflation expectations feed into long-term interest rates, it's the financial markets'

expectations that matter.

In short, given the importance of inflation expectations as a driving force of many economic
decisions, we need to understand how all of the different groups across the economy form their

inflation expectations so that we can do our best to keep them anchored.

So today I'm going to discuss some of the latest research in this area, which we have conducted
ourselves and in partnership with our colleagues in academia. This includes a Research Discussion
Paper that has been released in parallel with this event, which explores some of the points below in

more detail - I encourage you all to have a look at my colleagues' work. [12]

The presentation I am giving today draws heavily on a presentation at one of the first 'Policy Issues
Meetings' with RBA Board members earlier this year. As previously highlighted by Governor Bullock,

these meetings:

... assemble a group of staff with the right experience and expertise to give the members insights
and diversity of perspectives on the key issues relevant for policy. It will provide analysis of issues

that are relevant to a few upcoming [Board] meetings, not just the immediate one, !11]

These new meetings have been very well received by Board members. They have appreciated the
opportunity to explore policy-relevant topics in more depth and to meet with more of the staff that
are engaged in the work. In turn, staff have valued the additional engagement with their work, so it's

been a clear win-win.

For most of this speech, I'll be focusing on household and union expectations, and mostly on short-
term expectations. In the past, how these groups form expectations has been less well-understood,

and this is why we've focused our latest research here.

But before turning to unions and households, it is worth mentioning that we have a reasonable
understanding of how financial markets form expectations. Financial markets efficiently incorporate
signals about the likely future direction of inflation into market prices; by taking active positions that
are contingent on economic outcomes, it's no surprise that market participants keep themselves very
well-informed about what's happening. From these prices, we can discern whether their short- and

long-term expectations remain anchored to the RBA's inflation target. [12]

To understand how households and unions form their expectations, we've collaborated with academic
colleagues to develop a very general model approach that we've then applied to different data series.
The model assumes that some people form their expectations by extrapolating from their previous

experience. That is, they assume that their experience of price increases in the past are a good guide

for what they'll experience in the future. The model also assumes that some people build on this and

take account of forward-looking information as well. For example, they might expect to see a sharp

increase in grocery prices in the future if it's reported that the harvest has been poor.

The first iteration of the model was run through to around the middle of the pandemic. The graph
shows the fit of the model to actual data. In the grey lines are unions' one- and two-year-ahead
expectations, and households' one-year-ahead expectations (Graph 6). 23] And then the blue lines

are the model estimates of each of these. [141

Graph 6
Inflation Expectations

% Unions one-year-ahead %
6 6
5 Expectations 8
4 4
3 3
2 Model 2
1 1
% Unions two-years-ahead* %
6 6
5 5
4 e 4
3 3
2 2
1 1
° Households one-year-ahead °
5 5
4 4
3 3
2 2
1 1
(0) {of I ft ft ff ft ff ft tt 0

1999 2004 2009 2014 2019 2024

* Dots used for model estimates pre-2004 due to data availability.

Sources: Australian Council of Trade Unions; Beckers and Brassil (2022);
Brassil, Haidari, Hambur, Nolan and Ryan (2024); Employment
Research Australia; Melbourne Institute; Workplace Research
Centre.

We think the model did a reasonable job over the historical period. Especially for unions, where the

model pretty much captured every major wiggle in their expectations.
We've learned a lot from this process, but there are three key insights that I want to highlight:

1. We estimate that around three-quarters of households and unions form their expectations by
extrapolating from their lived experience. That is, they observe what inflation was yesterday and
compare it to what they expected. Every time inflation turns out higher than what these people
expected, they partially adjust their expectations up.

2. This extrapolation process happens a lot slower for households than it does for unions. That is,
households only adjust their expectations a small amount each time they are surprised. As a
result, inflation has to be persistently higher or lower than previously expected for expectations

to change significantly.

3. The remaining one-quarter of unions and households don't just extrapolate, they incorporate a
lot more of the broader economic information available to them (beyond inflation outcomes
themselves) to make forward-looking judgements about where inflation is likely to go. In
principle, this is similar to the RBA's forecasting process - we look at past outcomes and forward-

looking indicators to assess how we think inflation will evolve from today.

Of the roughly 25 per cent who take on board additional information, this could come from a number
of different sources. To carry on my groceries example from earlier, in 2011 this group might have
expected that banana prices would shoot up in the months after Tropical Cyclone Yasi struck northern
Queensland, given the reporting of the damage to that year's crop. !1°] Or this group could be
looking at economic forecasts - including the RBA's - to get a sense of where inflation may be

heading.

With this better understanding of how people form their inflation expectations, we can now assess

how they have evolved recently, relative to what the models expected they would do.

Less extrapolation recently could reflect greater attention to
inflation or recognition that the recent episode is temporary

The orange line is the model's prediction for how inflation expectations would evolve during the
recent high-inflation period (Graph 7).!+°! While inflation was rising, expectations were evolving in-
line with the model's output. But the model suggested that the turning point in expectations would

come later. So expectations are currently lower than our models thought would be the case. !171

Graph 7
Inflation Expectations

% Unions one-year-ahead %
6 6
5 Expectations 8
4 Prediction 4
3 3
2 2
1 1

% Unions two-years-ahead %
6 6
5 5
4 4
3 3
2 2
1 1

° Households one-year-ahead ie
5 5
4 4
3 3
2 2
1 1
ot __1_1_1_1_1_1_1_1_1_1_1_1_1_1_1_/9

2008 2012 2016 2020 2024

Sources: Australian Council of Trade Unions; Beckers and Brassil (2022);
Brassil, Haidari, Hambur, Nolan and Ryan (2024); Employment
Research Australia; Melbourne Institute; Workplace Research
Centre.

As best we can tell, the models missed the turning point because unions and households have been
extrapolating less from the recent high inflation outcomes. '18] The model attributes part of this to
an increase in the share of people who take on board forward-looking information, from around one-

quarter to over two-thirds for unions.

This finding is consistent with a theory known as the 'rational inattention' hypothesis. !1°] The idea
being that when inflation is low and stable, extrapolation from the past provides a reasonably

accurate expectation of the future, so it is not worth paying more 'attention'. Conversely, when

inflation does not fit this pattern - for example, in the recent past when it was much higher -
extrapolation might provide a poor forecast. So it is 'rational' for people to put more effort into

thinking about where inflation will head next.

Another finding from the model is that those who use previous inflation to form their expectations,
that is they use yesterday's experience to guide today, have been adjusting their view more slowly in
recent years. A possible reason for this is that some people have seen the recent experience as
atypical and so don't expect it to continue - given the nature of the shocks (the pandemic and then
the conflict in Ukraine), it's easy to understand this. So while this group only use previous inflation
outcomes to form their expectations, they do appear to adjust how much weight they put on specific

outcomes to take account of broader economic conditions.

Unfortunately, these are just plausible hypotheses at this point, we don't have enough evidence to be
definitive. If once inflation sustainably returns to the target band expectation formation reverts to
how it was before the recent episode, that would provide further evidence in favour of these
hypotheses. But more importantly, it would give us comfort that in future inflationary episodes,

expectation formation might similarly change in a way that mutes the increase in expectations.

Another possible explanation is that some more 'salient'
prices have evolved differently to average prices

In everything I've shown so far, we assume that the price increases that matter most are the ones
that people spend most of their money on. Which is exactly how the Consumer Price Index, or CPI, is

constructed.

But that might not be how people extrapolate from what they have previously observed to form their
expectations. Our lived experience is that we 'see' some prices much more frequently than others,

and that some price changes are more noticeable than others.

Prices that change regularly or that people pay often may be particularly influential when people form
their expectations - they're more visible, and they could be seen as a proxy for what's happening to

all prices across the economy. These are known as salient prices. '291

While there are some obvious candidates for prices that may be salient - such as fuel, groceries,

rent, and energy prices - determining how salient they are has unfortunately proven difficult.

The strongest result we have obtained is with respect to petrol and diesel prices - that is, the prices
you see changing every day when you drive past a petrol station or fill your car up. For other
potentially salient prices, whether or not our models identify them as salient depends on the various
other modelling decisions that are made. But for fuel prices, it doesn't seem to matter what you do to

the model, these prices almost always show up as salient.

Having said all that, allowing for fuel to be a salient price in the model does not significantly change
the model's estimate of inflation expectations most of the time. This occurs because fuel prices are
volatile and households learn slowly. So it actually takes an extended period of fuel prices evolving
differently to other prices before there would be a meaningful impact on expectations (according to

the model).

But that's exactly what we have seen in the past few years (Graph 8). From the beginning of 2021
until mid-2022, fuel price inflation was much higher than average price inflation, increasing

61 per cent over this period. !2+! But for most of the period since then, fuel price inflation has been
around its historical average, while much of the broader consumption basket has continued to

experience above-target price inflation.

Graph 8
Expectations and Fuel Inflation

% Household inflation expectations %
One-year-ahead

% Year-ended fuel inflation %
20 A 20
0p" 0
-20 W -20

-4gC+_1_11__1tt_ttitttittotititiititititiitititt.a4g
1999 2004 2009 2014 2019 2024

Sources: ABS; Brassil, Haidari, Hambur, Nolan and Ryan (2024);
Melbourne Institute.


So, for household's expectations, accounting for the salience of fuel prices can at least partially
explain why the simpler inflation expectations model presented earlier predicted that short-term

inflation expectations would remain higher for longer.

Conclusion

To conclude, recent research has improved our understanding of how people form inflation
expectations. As a result, we have been able to better analyse how expectations have evolved during

the recent high-inflation period. And it's a good news story with respect to expectations:

» Short-term expectations appear to be converging towards long-term expectations, and these have

remained anchored through the recent past.
» There's no evidence of expectations being more persistent than normal.

» And there's even some evidence of households and unions extrapolating less from recent inflation,

at least during the period of higher inflation.

» We need to be mindful of certain prices that may be particularly 'salient' for households. But such

prices work in both directions, and recently have been working to bring expectations down faster.

Endnotes

[*] I would like to thank Anthony Brassil and Callum Ryan for their assistance in writing this speech. Helpful feedback
was provided by Michelle Bergmann, Samuel Evangelinos, Andrew Hauser, Brad Jones, Christopher Kent and Martin

McCarthy.
[1] For further discussion, see Bullock (2024); Wood, Chan and Coates (2023); Beckers et a/ (2024).
[2] Fora fuller discussion of the costs of high inflation, see Bullock (2024).
[3] For surveys of US and European households, see Charm et al (2022); Bazzoni et a/ (2022).

[4] Economic history is clear that hyperinflation, where expectations are completely de-anchored and money supply
growth is extremely rapid, produces very bad outcomes (e.g. the experience of Germany in the early 1920s,
Hungary in the 1940s, through to Zimbabwe and Venezuela in the last 20 years). There is also plenty of evidence of
poor outcomes under high inflation experiences, such as the United States in the 1970s (see Blinder (1982) for a
short summary) and Turkiye today. On the other side, Japan's experience over the last 30 years highlights the

difficulties of zero inflation/deflation.

[5]

[6]

[7]

[8]

[9]

[20]

On the pass-through of labour costs into prices, see Ampudia, Lombardi and Renault (2024); Chin and Lin (2023);
Suthaharan and Bleakley (2022).

For an analysis of union bargaining power, see Bishop and Chan (2019).

For discussion on the policy flexibility afforded by anchored expectations, see Bernanke (2013); Borio et a/ (2023).

For detailed expositions, see Moore (2016); Beckers and Brassil (2022).

See RBA (2024) for a recent assessment of inflation expectations. In Graph 5, the 'adjusted bond market measure'
extracts the expected inflation rate from bond market prices using the Hambur and Finlay (2018) affine term-

structure model, the parameters of which are disciplined by survey data.

See Brassil et a/ (2024).

Bullock (2023).

The anchoring of these expectations is discussed further in RBA (2024).

For the model estimates of unions' two-years-ahead expectations, dots are used prior to 2004 due to model data
availability. For more information, see Beckers and Brassil (2022). The household measure of expectations used in
this research is the average of responses excluding responses in exact multiples of five (i.e. 5, 10, 15 etc) as
constructed by Haidari and Nolan (2022). This measure is used because the average that includes these rounded
responses has a large upward bias relative to historical inflation outcomes. While there are other methods of
removing this bias, previous research has found that changes in rounded responses tend to reflect changes in
uncertainty: see, for example, Binder (2017); Reiche and Meyler (2022). And while uncertainty affects decision-
making, the mechanism is separate to how inflation expectations affect decisions. The authors of this research
therefore conclude that removing rounded responses is a more transparent and well-justified approach to removing

this bias than other methods.

For details of the model, see Beckers and Brassil (2022); Brassil et al (2024); Brassil, Gibbs and Ryan (forthcoming).

Banana prices increased by over 400 per cent between June 2010 and June 2011.

The 'prediction' uses the original model estimates and then projects the model forward using the model inputs

available at each point in time. See Brassil et a/ (2024) for model details.

Unions' expectation data are available until September 2023.

See Brassil et a/ (2024)

See, for example, Sims (2003); Coibion et a/ (2020); Afrouzi and Yang (2021); Mackowiak, Matéjka and Wiederholt
(2023).

For further discussion and exploration of salient prices, see Binder (2018); D'Acunto et al (2019); De Fiore et a/
(2022); Kilian and Zhou (2022); Chua and Tsiaplias (2024); Anesti, Esady and Naylor (2024).

[21] Percentage increase in automotive fuel between December 2020 and June 2022 (from monthly CPI data).

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