Statement on Monetary Policy – August 2024Box A: Are Inflation Expectations Anchored?

Inflation expectations are the rates of inflation that people expect over some future horizon. These matter because actual inflation partly depends on what people expect it to be and build into their wage- and price-setting behaviour. We consider inflation expectations to be ‘anchored’ if they are stable at a level that is consistent with inflation being maintained at the midpoint of the target band (2½ per cent) over an appropriate period. This Box outlines a range of measures of long-term inflation expectations and where we estimate them to be at present, concluding that long-term inflation expectations in Australia are anchored.

Inflation expectations influence actual inflation outcomes as well as the ease (or difficulty) with which the RBA can achieve the inflation target.

If workers and firms expect future inflation to be high, they will build those expectations into their wage and price setting, causing actual inflation to be higher than otherwise. For that reason, a key goal of policy is to ‘anchor’ these expectations on the midpoint of the target band. If long-term inflation expectations become less anchored, monetary policy will have to respond more strongly to stabilise inflation and output. A credible commitment to do what it takes to hit the inflation target is a key factor in keeping expectations anchored, which is why the Board remains resolute in its determination to return inflation to target.[1]

We monitor a range of measures of inflation expectations.

We look at measures of inflation expectations of households, firms, union representatives, market economists and other participants in financial markets over a variety of time horizons. In this Box we focus on long-term inflation expectations to infer whether inflation expectations are anchored because short-term inflation expectations can be affected by temporary factors. Graph A.1 shows the long-term measures of inflation expectations that are currently available with a sufficient history to infer if expectations are anchored; all of these measures refer to expectations about headline CPI.

Graph A.1
A line graph showing long-term inflation expectations, including measures from the RBA’s survey of market economists, consensus economics, inflation-linked bonds and inflation swaps. The graph shows that long-term expectations have increased over the past year but remain between 2 and 3 per cent.

Survey measures of long-term inflation expectations of economists and forecasters tend to be quite steady around 2½ per cent. These measures are consistent with the inflation target.

Financial market measures of inflation compensation tend to move around a bit more than survey measures, but have mostly stayed within the inflation target band. These measures are implied from inflation-linked bonds and swaps; the returns on these are linked to headline CPI, so those who trade in them have an incentive to form accurate inflation expectations.[2] However, inflation compensation may not provide a clean reading of inflation expectations because investors tend to demand a premium over and above their inflation expectations to compensate for other risks, such as liquidity risk and/or inflation risk (i.e. the risk that their inflation expectations are wrong). To estimate inflation expectations, we need to separate these other risk premia from inflation compensation. It is difficult to disentangle which risks investors are demanding higher (or lower) risk premia for, but the drivers can have different implications. While there is little economic signal about inflation expectations from liquidity premia, an increase (or decrease) in the compensation demanded for the risk that inflation turns out to be higher (or lower) than expected points to a shift in people’s perceptions of future inflation.

The inflation compensation implied by market measures has increased by around ½ percentage point since early 2023 and some measures are in the upper half of the target band (Graph A.1). Based on a range of estimates for bonds and swaps, as well as market liaison, we estimate that the increase in inflation compensation reflects a rise in inflation expectations and inflation risk premia, though more so the latter.[3] These markets are not very liquid, but liquidity has not changed much since 2023. Overall, this points to inflation expectations being around 2½ per cent (Graph A.2). While our assessment is that long-term inflation expectations of financial market participants are broadly anchored at the target, the increase in the premium for inflation risk could be a warning sign that the risk of a more substantial upward move in expectations has increased. We will continue to monitor this closely.

Graph A.2
A bar and line graph showing modelled inflation compensation in government inflation linked bond markets for the five years starting five years ahead as the line with expectations and risk components as bars. It shows that inflation expectations are at around 2.5 per cent, the middle of the target band. It also shows that risk premia in this market has trended upwards since 2022.

In addition to monitoring a range of measures, we also use a summary measure to capture the signal from various survey and market measures of inflation expectations over different time horizons. We call this ‘trend inflation expectations’ (Graph A.3).[4] This summary measure of forward-looking inflation expectations is a key input into the staff’s forecasting models (along with a lag of inflation, which accounts for backward-looking, or so called ‘adaptive’, expectations). Our measure of trend inflation expectations has been quite stable over the inflation-targeting period, remaining within the target range. Over recent years, it has drifted up to be closely aligned with the 2½ per cent midpoint, after drifting below the midpoint during the low inflation period before the pandemic. Trend inflation expectations are currently assumed to remain at the target midpoint over the forecast horizon in the staff’s forecasting models.

Graph A.3
A line graph showing year-ended trimmed mean inflation and the RBA’s model estimates of trend inflation expectations, which are computed using measures of consumer, market economist, union and financial market inflation expectations. It shows that estimated inflation expectations have remained within the <span class=

A necessary condition for a measure of longer term expectations to be stable is that it is relatively insensitive to changes in actual inflation. We tested the sensitivity of long-term expectations, concluding that survey expectations and financial market measures tend to respond little to the latest inflation outcomes.

Our overall assessment is that long-term inflation expectations are still anchored.

The recent upward drift in some measures to around 2½ per cent, after a period of being below that, reflects closer alignment of expectations to the target. But there is a risk that a sustained period of inflation being above the target range could result in inflation expectations drifting higher. History suggests that if inflation expectations do rise above the target in this way, it would require more monetary policy tightening and a sustained and costly period of higher unemployment to lower inflation expectations and bring inflation back to target. Accordingly, it is important that inflation expectations remain anchored. Recognising this, the Board is committed to returning inflation to target within a reasonable timeframe.

Endnotes

For literature on the importance of a credible commitment, see Bernanke B (2003), ‘A Perspective on Inflation Targetting’, Speech at the Annual Washington Policy Conference of the National Association of Business Economists, Washington, DC, 25 March; Carvalho C, S Eusepi, E Moench and B Preston (2023), ‘Anchored Inflation Expectations’, American Economic Journal: Macroeconomics, 15(1), pp 1–47. [1]

The fixed rate in an inflation swap – where one party receives a payment indexed to inflation in exchange for a payment predetermined by a fixed rate – is the implied inflation compensation over the period of the swap. For bonds, the implied inflation compensation (or the ‘breakeven’ inflation rate) is the difference in yields on a nominal bond and an inflation-linked bond. [2]

For the bond market, we used a term structure model to decompose bond yields into expectations and risk premia: see Hambur J and R Finlay (2018), ‘Affine Endeavour: Estimating a Joint Model of the Nominal and Real Term Structures of Interest Rates in Australia’, RBA Research Discussion Paper No 2018-02. For the swap market (and as a cross check for the bond market), we produced alternative estimates of the inflation risk premium based on differences in long-term forward rates. [3]

Trend inflation expectations are estimated using a model that puts more weight on measures that can statistically explain future movements in all the expectation measures. [4]