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RBA releases research on inflation expectations

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The RBA has just published a RDP on how to model 'investor' (not consumer) inflation expectations in Australia. The paper distinguishes between expected inflation rates and inflation risk premia, which, by doing so, gives lower estimates of the former. Indeed, one might argue that the estimates appear downward biased, especially given the use of Consensus Economics economist survey estimates as a proxy for inflation expectations, which do not have a great empirical track record.

This dissection is also a statistical abstraction. When the RBA simply looks at inflation forward rates (see chart below), which is the simplest measure of inflation expectations, the story is clear: declining inflation expectations between the early 1990s and late 1990s, rising expectations from the early 2000s prior to the GFC, a temporary blip, and increasing five-year and 10-year expectations again.

In the RBA's words:

"The inflation forward rate reflects the relative prices of traded nominal and inflation-indexed bonds and is given by the sum of inflation expectations and inflation risk premia. As estimates of longer-term inflation expectations are relatively stable, movements in the five- and 10-year inflation forward rates tend to be driven by changes in estimated risk premia. The inflation forward rate … generally falls during the first third of the sample, rises around the time of the GST, and rises between 2004 and 2008, before falling sharply with the onset of the financial crisis then rising again."

For a larger image, click here.

Of course, these are just investor inflation expectations. An equally, if not more important, benchmark is consumer expectations. The Melbourne Institute consumer survey results are enclosed below. The pink (green) line is the 60- (90-) day moving average. Expectations have been heading in one direction since the early 2000s...

For a larger image, click here.

Published: Tuesday, March 15, 2011

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