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Economic & Financial Market Comment: Great Expectations

15/02/2017

I have great expectations for the future

Because the past was highly overrated

– Sylvester Stallone

Who would have thought that Sly had it in him to come up with a nifty quote (to be fair he has come up with a couple of others). But whether you agree with the above quote or not he touches on the importance of expectations, something that plays a big role in economics. And one area that expectations plays a particularly big role is inflation:

  • Expectations influences how firms set prices, and as a result how they manage their costs:
  • Expectations plays an important role in what price consumers are prepared to pay for goods and services, as well as helping to determine the size of the wage increase they demand (the largest cost for most employers);
  • Financial market inflation expectations plays a role in setting the level of interest rates, particularly longer-term rates;

Information is available for each type of inflation expectations. Business and consumer survey’s provide one indication. And there are a couple of products traded on financial markets that give an idea of investor views. Research from the RBA suggests that caution should be taken in reading the results too literally. Consumer inflation views can get heavily influenced by the movement in prices of regularly purchased goods (such as petrol). The reading of financial market views can be influenced by how heavily those products are traded (in the jargon, their ‘liquidity’). Nonetheless, the different measurements do provide a broad gauge as to what inflation expectations are throughout the economy.

From an economic standpoint, the reason expectations matter is that they can be reinforcing. In the 1980’s inflation was high, and both firms and consumers expected it to remain high. This made it difficult to achieve low inflation. Last year a number of global central banks became concerned that inflation would stay too low for too long. The worry was that this would lead to a fall in inflation expectations, increasing the problems in getting inflation higher. Too low inflation expectations has been a problem for the Bank of Japan for years in their fight to push Japan clear of deflation.

Given that inflation has been low in recent times, it is no surprise that everyone expects future price changes to also be low. Firms say that the price rises they are currently achieving are well below those available in the pre-GFC salad days (although they have risen a little in recent months). Problems in achieving a decent price rise is an issue across all industries. This indicates that most firms are facing the same macroeconomic challenges (modest global growth, strong competition, an above average level of the $A and low national income growth). One bit of good news is that firms are starting to believe they will be able to get a higher price rise next quarter. The not-so-good news is that the expected price change is still low.

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One reason that firms are finding it difficult to achieve a decent price increase is that consumers expect low prices. Median consumer inflation expectations are currently near their lowest level in over twenty years. But because consumers expect inflation to be modest workers are likely to continue to ask for relatively lower wage rises. Firms have been counting on moderate growth in labour costs to maintain profitability.

Low inflation expectations amongst consumers is not just an Australian phenomena. They are also very low in the US and New Zealand. This highlights that the forces keeping price growth are global:  the sluggish pace of the international economy and strong competition. An exception is the UK, where the large fall in Sterling has led the English consumer to expect to pay more for their bacon and eggs over the coming year.

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Perhaps the most optimistic group expecting higher prices is financial markets. Investor inflation views have risen since February 2016 as a result of improved views about the global economy and the rise of commodity prices. Despite the rise, market inflation expectations are still below the level typically seen before the GFC (a period of very strong growth for Australia and increasing commodity prices). Market inflation expectations have risen more in the US than Australia reflecting the stronger state of the US economy.

image-3-economic-update-15-02-17

The RBA expects inflation to increase modestly over the next two years, reflecting an economy expected to perform around average, a steady unemployment rate and low wage increases. The relatively low level of inflation expectations reinforces that view. The good news is that both actual inflation and expectations look to have bottomed. But the low level of inflation expectations does suggest that inflation is more likely to surprise as being too low. This suggests that if there is to be a rate change this year it is more likely to be down.

“I’ll be back” was one of the iconic movie quotes by that other well-known tough-guy actor, Arnold Schwarzenegger. Central banks are increasingly thinking that a pickup of inflation is coming back. We will see.

We live in interesting times.

This blog post is for general information purposes only and is not intended as financial or professional advice. It has not been prepared with reference to the financial circumstances of any particular person or business and should not be relied on as such. You should seek your own independent financial, legal and taxation advice before making any decision about any action in relation to the material in this article.

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