Australian inflation expectations are falling and the RBA may not be able to do anything about it

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Mirroring the movement in Australia’s actual inflation rate, inflation expectations — where consumers believe inflation is heading — has been moving lower in recent years.

This is no better demonstrated than in the chart below, supplied by ANZ economists Giulia Lavinia Specchia and Kieran Davies.

That’s the bank’s consumer inflation expectations index, a component within the broader consumer confidence index released in conjunction with Roy Morgan each and every week.

According to ANZ, the survey asks consumers whether they expect inflation to increase, stay the same, or decrease over the next two years. They are also asked to estimate where inflation is likely to sit over the next two years.

Inflation expectations looking two years ahead have been falling since 2011, mirroring the trend in other measures from union officials, financial market expectations and private sector economists.

Since late 2011, roughly the time expectations started rolling over, the RBA has delivered 300 basis points in rate cuts to support the domestic economy, more recently in an attempt to help boost inflationary pressures. However, despite that extra stimulus and lower Australian dollar, inflation, whether measured in actual terms or expectations, has failed to respond.

At 1%, the annual rise in the consumer price index in the June quarter was the weakest seen since mid-1999. Core inflation, the RBA’s preferred inflation measure, didn’t fare much better at 1.5%, the lowest level on record.

It’s a quandary for RBA policymakers and, according to ANZ, one that they may not have much control over.

Based on modeling from ANZ, Specchia and Davies discovered that movements in petrol prices have a significant positive impact on inflation expectations, a relationship the pair described as “somewhat concerning”.

“It implies that domestic inflation expectations largely react to global developments — i.e. falling commodity prices and global inflation expectations — which the RBA cannot influence,” the pair wrote.

As much as they would like to, the RBA cannot control factors out of its control such as global commodity prices. While no doubt helping inflation at the margin, recent rate cuts may not have done much to influence the main factor that has been driving expectations lower.

Though they plan to investigate further, stating that the modelling may not be capturing all domestic influences on inflation expectations, the preliminary analysis does create question marks over whether the RBA will be able to boost inflationary pressures as its forecasts currently suggest.

As my colleague, Greg McKenna, wrote last week, central bankers try to manage inflation, the economy, and unemployment via interest rates, acknowledging that “expectations are important because inflation whether too high, or too low, changes consumers’ behaviour and can become economically destabilising”.

Declining inflation expectations may feed into lower wage growth, leading to weaker economic activity, which in turn could lead to even lesser price pressures within the domestic economy. And then the cycle repeats, potentially leading to even greater disinflationary forces, or worse.

One only has to look at the Japanese economy over the past 25 years to see how “economically destabilising” de-anchored inflation expectations can be, particularly for a nation with a heavily indebted private sector.

Though ANZ sees interest rates remaining unchanged at 1.5% for the foreseeable future, Specchia and Davies believe that a further decline in inflation expectations could see the RBA add to the 300 basis points of easing seen over the past five years.

“If this happened, we think it could trigger further monetary easing in an effort to lower the real interest rate, thereby ensuring that inflation eventually returns to the 2-3% target band,” they say.

“This is because lower inflation expectations may feed into lower actual inflation, which is already below the Bank’s 2-3% inflation target and is forecast by Bank staff to stay low for an extended period.”

After rate cuts from the RBA following the March and June quarter CPI reports this year, the ABS’ September quarter inflation report — due out on October 26 — has taken on even more importance than usual.

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