RDP 1999-03: Householders' Inflation Expectations 5. Conclusion

While inflation expectations play a central role in the economic process, less is known about the nature of expectations and how they are formed. In this paper, we examined the properties of inflation expectations as measured by the Melbourne Institute survey of householders. Three key results emerge from the analysis.

The first is that householders' average inflation expectations vary according to individual characteristics. People with better access to information or with more developed information-processing skills – for example, people in professional jobs, those who have more education or those who are older – have, over the past four years, had inflation expectations which were systematically lower and closer to actual inflation. Inflation expectations of householders with these characteristics have also been more responsive to what is happening with actual inflation.

Second, when asked about prospects for the economy and jobs, people associate ‘good times’ with low inflation and low unemployment. On the face of it, people prefer low inflation; high inflation makes people feel worse off.

Third, there is little evidence that people form their expectations about future inflation on the basis of the sort of economic relationships highlighted by economists. Inflation expectations do not systematically respond to key macroeconomic variables such as the output gap, import price inflation, changes in bilateral or multilateral exchange rates, wages growth or changes in unit labour costs. Only the unemployment rate affects inflation expectations, but contrary to economic intuition, it has a positive effect. Accordingly, inflation expectations fail standard tests of rationality, with evidence of a bias in expectations and of householders not using all available information, such as past inflation and exchange rate movements, in forming their expectations.

But while householders' views about economic relationships differ from those of economists, their inflation expectations do appear to be directly affected by monetary policy. Inflation expectations systematically fall a few months after the cash rate rises. People may not be sure of the mechanism by which monetary policy affects inflation, but they do think that it will have an effect.