Analysis: Rising inflation expectations mean Central Banks will need to be hawkish
Russia’s invasion of Ukraine has seen commodity prices soar on the back of sanctions and supply chain disruptions. Such a spike in prices has implications for inflation as well as for economic activity, presenting a dilemma to central banks given an already problematic inflation picture. In this Weekly we explore how central banks might balance the two conflicting forces – inflation expectations key according to Fed speak.
US Fed Governor Waller emphasised the importance of inflation expectations, noting that he would be “monitoring carefully to see whether expectations rise out of a range that would suggest they are becoming unanchored” and that “keeping longer-term inflation expectations anchored is vitally important”, (see: Waller: Fighting Inflation with Rate Hikes and Balance Sheet Reduction).
Fed Chair Powell also emphasised this point in his Senate Testimony recently: “We know that the best thing we can do to support a strong labor market is to promote a long expansion, and that is only possible in an environment of price stability” and “We will use our policy tools as appropriate to prevent higher inflation from becoming entrenched…), (see Powell: Semiannual Monetary Policy Report to the Congress).
To analyse developments in inflation expectations, we re-create the Fed’s Common Inflation Expectations Index, which summarises 21 indicators of inflation expectations. On our estimate, US inflation expectations at Q1 2022 are at their highest level since 2011. With core inflation running at 6.4% y/y, the risk of higher inflation being entrenched is very real. This will keep the Fed hiking even amid growth headwinds.
In Australia, inflation expectations have also started to pick-up, and while lagging developments in the US, look to be trending in the same direction. RBA Governor Lowe recently highlighted the importance of inflation expectations and wage expectations in terms of whether higher prices can “wash through…without the inflation psychology shifting” and suggested the Board will consider this at each meeting.
My colleague Ivan Colhoun noted last week the plethora of inflation anecdotes that have been reported in the Australian press recently. Since then, consumer inflation measures have picked up further, while the NAB Business Survey has both final prices and purchase costs at their highest levels in the history of the series. Replicating the Fed method in an Australian context finds inflation expectations at 2013 levels.
The potential for higher inflation to weigh on demand is of course very real and something that central banks will be watching closely as they hike rates. A quick calculation based on oil prices suggests the rise in petrol prices since Q4 would have around the cashflow impact on the household sector of a 25bps rate increase. In Europe, which is facing considerably higher gas prices, evidence of demand destruction is also emerging.
In this environment central banks will act cautiously but will still be committed to achieving their inflation targets. Markets are likely to factor in shallower tightening cycles and bring forward when cycles end, depending on how Russia/Ukraine evolves.
Chart 1: US inflation expectations have risen to be above long-run average levels
Chart 2: Russia/Ukraine a factor, but not a restraint on rate hikes so far given financial conditions have only risen to average