Our perceptions about expected inflation have important consequences. It influences how we (or the trade unions we belong to) negotiate wages, our willingness to buy a house, and businesses’ decisions to invest or not.
Inflation determines how many goods and services we can purchase with our current salary. Inflation expectations, however, determine whether future goods and services will be more or less affordable and therefore how we will behave today. If we believe inflation will be 10% next year and our salary increase only 5% (leading to a decline in our purchasing power), we might be less likely to buy that new car.
Measuring inflation expectations and determining what influences peoples’ inflation expectations is therefore important to policy makers, notably, in South Africa’s case, the SA Reserve Bank (SARB).
Controlling inflation expectations is the first step to controlling inflation. If there is a shock to a particular price (such as oil), the macroeconomic consequences will be limited if South Africans believe that Governor Lesetja Kganyago and his Monetary Policy Committee (MPC) will bring inflation under control. If the response of the rest of the economy to the oil shock is muted, the process of inflation won’t get under way.
What do we know about the determinants of inflation expectations? Not much, it turns out. It’s quite difficult to measure inflation expectations. Surveys are often used, but usually of economists in the financial sector; they don’t necessarily gauge the perceptions of the proverbial man-on-the-street.
A new paper published in Economic Modelling by Stellenbosch University economist Monique Reid begins to shed light on the topic. She uses ten years of data from an inflation expectations survey by the Bureau of Economic Research to investigate how quickly the message from the SARB trickles down to the general public. Information is ‘sticky’, Reid finds, and for some groups more than others: financial analysts, for example, adjust their expectations quicker and more accurately than businesses and labour unions. This is because financial analysts have the ability and skill to use and understand other sources of information (like MPC announcements or international economic indicators) than simply the past inflation rate.
A recent paper by two US economists, Ulrike Malmendier and Stefan Nagel, in the The Quarterly Journal of Economics shows that even amongst the general public there is significant variation in inflation expectations. They find that own life experiences determine how individuals form expectations of the future. How would this work?
Say inflation over the last five years has been lower than the average for the last three decades. They show, using 57 years of data of US inflation expectations, that a young person who entered the job market five years ago would be more likely to expect lower inflation than someone who had been employed for longer and had thus experienced both high and low inflation regimes.
If this is true for SA, young South Africans are more likely to expect lower inflation, because the inflation rate in the sixteen years between 1999 (the year SARB started with inflation-targeting) and 2014 averaged 5.2%. South Africans entering the job market during this period would have experienced a low-inflation regime. But those entering the job market in the sixteen years between 1976 and 1991 witnessed an average inflation rate of 14.1%.
This has important implications for policy makers, financial sector managers and their clients. Behavioural economists repeatedly demonstrate that people have biases that they are often unaware of (in this case, a mix of the availability and familiarity heuristics). Younger financial advisors may weigh the recent low-inflation regime more heavily than older advisors would. An obvious way to diffuse such unknown biases is to have teams with advisors of different ages.
Such biases also influence household borrowing and lending behaviour. Younger people may, for example, be more inclined to choose variable-rate investments given that during their lived experience rates never varied dramatically. Older homeowners who remember the trauma of the 1998-rate hike, may prefer fixed-rate investments.
Policy makers in the SARB need to take heed of these findings and include demographic characteristics of consumers into their models of inflation expectations.
*This article first appeared in the Finweek magazine of 29 October.