What do we mean by inflation expectations and why do they matter?

Inflation expectations refer to the anticipated rate of inflation that consumers, businesses, financial markets, and policymakers expect to prevail in the future. It is a forward-looking concept and plays a crucial role in shaping economic decisions and behaviour. Inflation expectations are based on individuals' perceptions of how prices will change over time and can influence a wide range of decisions including spending, saving, borrowing, and investing.

There are two main types of inflation expectations:

1. Consumers' (Households') Inflation Expectations: These are the expectations held by households and individuals about the future rate of inflation. Consumers' inflation expectations can impact their purchasing behaviour and financial planning. If consumers expect higher inflation, they may choose to spend more now to avoid higher prices later. Conversely, if they anticipate lower inflation or even a period of price deflation, they might delay purchases, leading to reduced consumer spending and a rise in the propensity to save.
2. Businesses' Inflation Expectations: These refer to the expectations of businesses and firms about future inflation. Businesses' inflation expectations can influence their pricing decisions and investment strategies. If businesses expect higher costs due to inflation, they may raise prices for their goods and services to maintain profitability. Additionally, inflation expectations can affect wage negotiations with employees and suppliers.

Inflation expectations are also crucial from a monetary policy perspective. Central banks use inflation expectations as an important input when formulating their monetary policy decisions. Central banks aim to maintain price stability, typically targeting a certain inflation rate, and they monitor inflation expectations to gauge whether their policies such as changes in interest rates and the level of quantitative easing (QE) are effective in anchoring expectations.

Stable, anchored inflation expectations

When inflation expectations are well-anchored and stable, it means that businesses and consumers have confidence in the central bank's ability to control inflation. In such cases, actual inflation tends to be more predictable and less volatile.

On the other hand, if inflation expectations become unanchored and start rising rapidly, it can lead to a self-fulfilling inflationary spiral. People may expect higher inflation, leading to increased wage demands and price hikes, which, in turn, drive actual inflation higher.

People's expectations about future inflation are often based on past inflation rates. If inflation has been high in the past, people are more likely to expect high inflation in the future.

Higher expected inflation can lead to a wage-price spiral

A wage-price spiral, also known as wage-price inflation, is a self-reinforcing cycle in which rising wages lead to higher production costs for businesses, which, in turn, result in higher prices for goods and services. These higher prices, in turn, lead to demands for further wage increases to maintain the purchasing power of workers, continuing the cycle.

How can a change in inflation expectations affect the Phillips Curve?

The Phillips Curve depicts the possible inverse relationship between inflation and unemployment in the short run. It suggests that when unemployment is low, inflation tends to be higher, and vice versa. However, the relationship between inflation and unemployment is not fixed and can be influenced by various factors, including inflation expectations.

When inflation expectations change, it can impact the Phillips Curve in the following ways:

Shifting the Phillips Curve: Changes in inflation expectations can cause the Phillips Curve to shift. If inflation expectations rise, the Phillips Curve may shift upward, indicating that at any given level of unemployment, higher inflation is anticipated. Conversely, if inflation expectations decrease, the Phillips Curve may shift downward, implying lower expected inflation rates at each level of unemployment.

• Expectations-Aware Wage Bargaining: In an environment of well-anchored inflation expectations, workers and businesses make wage bargaining decisions with those expectations in mind. If inflation expectations rise, workers may demand higher wage increases to maintain their real wages (adjusted for inflation). This can lead to higher nominal wage growth even at low levels of unemployment, potentially pushing the economy along the Phillips Curve.
• Inflation Persistence: Inflation expectations can influence actual inflation rates over the long term. When people expect higher inflation, they may anticipate further price increases in the future. This expectation can lead to a self-fulfilling prophecy, as businesses may raise prices and workers may demand higher wages in anticipation of future inflation, thereby sustaining higher inflation rates.
• Adaptive Expectations vs. Rational Expectations: The impact of changing inflation expectations on the Phillips Curve can depend on whether individuals and firms have adaptive expectations or rational expectations. Adaptive expectations are backward-looking, where people base their expectations on past inflation rates. In contrast, rational expectations are forward-looking, where expectations are formed by considering all available information, including future policy actions. If people have rational expectations, the Phillips Curve may be more stable, as their expectations are influenced by more than just past inflation rates.