RDP 2024-07: How Do Households Form Inflation and Wage Expectations? 1 Introduction

Inflation expectations play a crucial role in modern macroeconomic models and monetary policymaking. This is because inflation expectations are thought to play an important role in wage and price setting, and a growing literature has found a causal link between inflation expectations and household and firm behaviour (e.g. Coibion et al 2023). More generally, the ability of central banks to influence and anchor expectations via credible inflation targets is widely credited for moving economies from the Great Inflation of the 1960s and 1970s to the Great Moderation of the 1980s and 1990s (Bernanke 2004; Bordo and Orphanides 2013).

There is also a growing but relatively small literature examining the formation of wage expectations. Understanding the formation of wage expectations is important as wages are a key component of households' incomes and firms' costs. And the link between inflation and wages expectations can be extremely important. For example, as inflation rises workers may want to maintain the real purchasing power of their labour income, and so wage and inflation expectations may be mechanically linked. To the extent that this feeds into higher prices, this can put further upwards pressure on prices and amplify the effects of supply or other shocks. Thankfully, recent work suggests that the extent to which this amplification leads to a spiralling of wages and prices is limited in advanced economies (Alvarez et al 2022).

In this paper we add to this literature by examining the formation of short-term wage and inflation expectations in Australia using the Melbourne Institute Consumer Survey, applying common approaches and frameworks, including that of Brassil, Gibbs and Ryan (forthcoming), to both expectations. We document several stylised facts:

• There is a negative relationship between conditions/spending intentions and expected inflation, but a positive one between conditions/spending intentions and wages.
• The contemporaneous relationship between wages expectations and inflation expectations is relatively weak.
• Estimated monetary policy shocks (an example of a demand shock) have a limited effect on expectations.
• Oil price shocks (an example of a supply shock) tend to raise inflation expectations and lead to (if anything) a decline in expected real wages.
• Inflation expectations appear to be more backward looking and based on past inflation, particularly for lower income households, while wages expectations appear more forward looking and based on a broader information set.
• Households appear to overweight past movements in certain prices, particularly fuel prices, in their inflation expectations.

These findings paint a picture of households having a somewhat ‘supply-side’ view of inflation, at least in the short term, but a more ‘demand-side’ view of wages, consistent with Jain, Kostyshyna and Zhang (2022). One potential explanation for this may be the outsized role of fuel prices in consumers' inflation expectations. If fuel prices are (perceived to be) primarily driven by supply shocks, this could help explain the supply-side view. That said, the overall estimated ‘additional’ effect of fuel prices on expectations is fairly small. An alternative explanation may be that households apply a good–bad heuristic, with inflation thought of as bad (e.g. Kamdar 2019). Relatedly, people may be focused on certain channels through which economic shocks propagate rather than others: they may focus on the effect of higher inflation, all else equal, on their real incomes, rather than the fact that higher inflation may reflect stronger economic conditions.

These findings have several related potential implications for policy. First, the findings are consistent with households potentially believing that there is relatively little trade-off between bringing down inflation and weakening economic activity, as found by Binetti, Nuzzi and Stantcheva (forthcoming). If this is the case, it may affect the central bank's ability to control inflation by influencing beliefs: if people don't believe that weaker economic conditions lead to lower inflation, communicating that policy is attempting to slow aggregate demand may not affect peoples' inflation expectations and therefore actual inflation. Moreover, if households do not believe that there is a trade-off, it may affect their willingness to face weaker conditions to bring inflation down. These issues all point to the potential benefits of effective communication and public education. Second, if people tend to associate inflation with worse economic conditions, communications about the inflation outlook may have unintended effects on households' expectations of economic conditions, as documented in Candia, Coibion and Gorodnichenko (2020). For example, communicating the importance of bringing inflation back to target following an inflationary shock could lead consumers to expect stronger economic conditions, thereby increasing the inflationary pressure.

More work is needed to draw stronger conclusions and policy lessons. For example, differentiating between some of the above explanations for the differing views of inflation and wages can help to derive more concrete recommendations for policy and communication. Unfortunately, given the difficulty in identifying the causal mechanisms that drive inflation (Read 2024), determining the causal mechanisms that drive inflation and wage expectations is likely to be even more challenging. Nevertheless, the findings generally point to the value of targeted and clear communication, as well as explanatory and educational material regarding economic channels and policy strategy.

Section 2 provides a review of the related literature. We then describe our data in Section 3, before analysing the relationship between inflation and wage expectations, and sentiment, in Section 4. Section 5 looks at the effects of various shocks on expectations, and Section 6 examines the forward- and backward-looking nature of the expectations, before Section 7 concludes.