Michele Bullock’s million-dollar inflation question

But Bullock says the RBA has to be careful that inflation expectations don’t become “de-anchored” for multiple years and “entrench” inflation.

“The longer inflation stays above target, and the more people observe it happening in their day-to-day lives, the harder it will be [to bring inflation down],” she said. “We have to alert people to the fact that if inflation continues to be higher than expected and the risks are on the upside, then we’re going to have to respond with monetary policy.”

The forward demand problem

Sticky inflation in labour-intensive industries such as hairdressing, car servicing and financial services will be the key factor influencing the RBA’s November decision in a couple of weeks’ time. But soaring oil prices and inflation expectations will also shape the RBA’s decision-making over coming months.

Vanguard senior economist Alexis Gray says inflation expectations change people’s behaviour, by bringing forward demand for products before anticipated price rises and pushing up prices further.

“If you feel inflation is going to be high, you’re more likely to run out and buy the next big purchase because you fear the price is going up in the future,” Gray says. Price rises also encourage workers to ask for higher pay rises, which can further fuel inflation. “It also affects wage negotiations,” Gray says. “It’s one of the reasons we have been more hawkish than some of our peers in expecting another one to two interest rate hikes.”

The RBA would have breathed a sigh of relief when headline inflation for July fell below the psychological 5 per cent mark, to 4.9 per cent. But rising fuel prices lifted inflation to 5.2 per cent in August.

Oil production cuts by Russia and Saudi Arabia, and conflict in the Middle East, have pushed up the international price of oil by about 30 per cent since late June to above $US90 a barrel. Combined with a weak Australian dollar, which makes it more expensive to import oil, the global energy price spike has caused petrol prices here to surge above $2 a litre.

Usually, the RBA “looks through” fuel price spikes caused by international supply factors and treats them as a temporary interruption. The RBA typically doesn’t rush to raise interest rates, focusing instead on “underlying” inflation that strips out volatile movements in fuel and food prices.

High oil prices tend to slow global economic growth, a likelihood Bullock flagged this week. Expensive fuel is effectively a tax on consumers and reduces their spending for other goods and services. These forces can be deflationary, at least for some sectors of the economy.

Moreover, the RBA knows that consumer spending is already weak due to the 12 interest rate rises. Hence, it’s possible businesses will feel they have less pricing power to pass on higher fuel costs and be forced to absorb those costs through lower profit margins. On the other hand, high fuel prices can add to costs in transport, manufacturing, agriculture and mining businesses, which can pass on the higher prices to consumers.

Grocery marker

The unquantifiable wildcard is inflation expectations. University of Melbourne economics professor Bruce Preston says experience of economic conditions affects views on inflation. People who lived through high inflation in the 1970s are conditioned to think inflation will be high, but – until recently, perhaps – Millennials who experienced low inflation pre-pandemic have thought inflation will be low in the future.

Economic research also shows regularly purchased items such as fuel and milk have an outsized effect on people’s inflation expectations. Bullock is evidently aware of this as the price of petrol soars.

A peer-reviewed paper in the Chicago-based Journal of Political Economy academic journal concludes that consumers rely on the price changes of goods in their grocery bundles when forming expectations about aggregate inflation.

“The weights consumers assign to price changes depend on the frequency of purchase, rather than expenditure share, and positive price changes loom larger than negative price changes,” Francesco D’Acunto, Ulrike Malmendier, Juan Ospina and Michael Weber write. “Prices of goods offered in the same store but not purchased do not affect inflation expectations.”

Inflation expectations are 20 per cent to 40 per cent larger due to the frequency of purchases, compared to the weighted prices of goods and services measured in the official US consumer price index basket.

Separately, research published by the American Economic Association finds that oil prices after the 2008 global financial crisis influenced household inflation expectations.

“Half of the historical differences in inflation forecasts between households and professionals can be accounted for by the level of oil prices,” write economists Olivier Coibion and Yuriy Gorodnichenko.

“Because gasoline prices are among the most visible prices to consumers, a natural explanation could be that households pay particular attention to them when formulating their expectations of other prices.”

Flexibility an issue

In Australia, automotive fuel accounts for about 3.5 per cent of the consumer price index goods and services basket. It’s not a huge component, but petrol is a fairly large individual item behind housing costs in household budgets, Vanguard’s Gray says.

“People are sensitive to changes because they feel it immediately when they go to the pump,” she says. “It tends to affect their short-run expectations of inflation over the next year, but not necessarily over longer time frames.”

Although short-term inflation expectations are high for the next 12 months, consumer and market expectations over the medium term for the next five years or so are still around 2.5 per cent, the midpoint of the RBA’s inflation target.

The RBA is determined to “anchor” inflation expectations to avoid inflation becoming self-fulfilling.

JBWere chief investment officer Sally Auld says: “Consumer inflation expectations tend to jump up and down a bit with the petrol price in the short term.”

Normally, central banks look through high petrol prices and consider that they will lead to consumer “demand destruction” on other items, she says. “In Australia, with inflation already higher, I worry we don’t have the flexibility to do that.”

The International Monetary Fund said last week that expectations were increasingly driving inflation dynamics and that central banks needed to influence these expectations to achieve a “soft landing”, “without causing a deep downturn in growth and employment.”

Hence, Bullock is talking tough by warning that the board has a “low tolerance for a slower return of inflation to target than currently expected” and is prepared to raise the cash rate beyond 4.1 per cent.

The straight-talking Bullock is putting on her best poker face to condition people into believing inflation will be brought under control.