Gulf opening up between actual and expected inflation

Posted on July 28, 2016 by Pete Faulkner - Inflation, Interest Rates, Uncategorized

Each month the Melbourne Institute release their Survey of Consumer Inflationary Expectations. This gives a good indicator where people believe inflation is heading. The chart below compares those expectations (on a quarterly basis) with the actual average core inflation data. What we see is that generally people’s expectations are, on average, higher than reality. Over the course of the past 17 years inflationary expectations have averaged 0.4% higher than the actual.

It also highlights that, where actual inflation moves significantly outside of the RBA target band (as happened through late 2007 to mid 2008), expectations tend to overshoot reality. Likewise, when the GFC struck and inflation started to fall quickly expectations again overshoot, this time on the downside.

What the 12 quarter moving average lines tell us is that since early 2014 when actual inflation started to fall away, expectations have remained consistently high. Indeed over the past few quarters we have seen an unprecedented divergence in these two measures opening up. Essentially consumers are saying “I don’t believe that inflation will stay this low for long”. Given the RBA’s success with inflation targeting over the long term (average core inflation over 17 years of 2.78%) we might understand why.

This is a very real example of the idea of rational expectations and a good reason as to why any potential lowering of the RBA’s inflation target should be treated with extreme caution. If the RBA acknowledges that core inflation, over the longer term, has settled into a lower range and they will therefore be targeting that lower range then in all likelihood consumers will start to adjust downwards their own expectations of inflation. This then compounds the very problem the Bank has been facing; trying to actually push inflation somewhat higher. There is a very real danger that we would then enter into a potentially deflationary spiral with lower expectations making further cuts in the Cash Rate less and less effective. Let’s not forget that the RBA’s supply of rate cut ammo is running ever lower as we head closer to zero.

Those advocating for a cut in the target rate might also like to ask themselves, “Would you be calling for an increase in the target if we happened to be experiencing 5% inflation at the moment?”