RBA Bullock: Inflation Psychology Critical For Inflation Outlook, Monetary Policy

--Inflation too high and increasingly broadly based
--Downside risks in China a significant concern
--Substantial uncertainty how high inflation, cost of living impact price, wage expectations
--How inflation psychology plays out is critical for inflation outlook, monetary policy
--Response of households to falling housing prices is uncertain
--Despite recent falls, housing price remain substantially above pre-pandemic level
--Final uncertainty around energy, other supply shocks boosting inflation
--Built large electricity prices into forecasts but risk we haven’t incorporated enough
--Even with modest jobless rate rise forecast, it will be close to lowest level in decades
--Good reasons to think we are approaching peak of inflation this cycle
--Underlying inflation pressures little stronger than previously thought
--Wages growth bit stronger than thought three months ago
--Further rate rises will be required; size and timing will depend on data

By Sophia Rodrigues

(Sydney, November 9, 2022)—The inflation psychology of households and businesses in response to current high inflation and cost-of-living pressures is critical for inflation outlook and for monetary policy, Reserve Bank deputy governor Michele Bullock said Wednesday.

Bullock also warned of the risk that the RBA may not have incorporated enough rise in electricity prices into its forecasts, despite already projecting “large increase.”

Bullock was speaking at the annual dinner of Australian Business Economists on the topic, “The Economic Outlook” where she reiterated the RBA message that further interest rate increases will be required to meet the objective, but the size and timing will depend on the data.

She noted the RBA has revised inflation forecasts a little, but “there are good reasons to think that we are approaching the peak of inflation this cycle.” After that the RBA expects rising interest rates and cost-of-living pressures to drive a moderation in consumption that brings demand more in line with supply.

Bullock talked about four key uncertainties related to the forecasts which is a reason why the RBA is continually reviewing incoming data and testing the forecasts.

The first significant concern is downside risks in China and the second uncertainty is what the current high inflation and cost-of-living pressures might do to price and wage expectations in Australia.

“How households and businesses respond to these pressures is going to be critical for the Australian economy and the path of monetary policy,” Bullock said.

It is quite possible workers will demand and may get wage rises and businesses might well be willing to pay higher wages if they think they can easily raise their prices.

“If this mindset were to take hold inflation will remain high,” Bullock said.

A third uncertainty is the behaviour of households to higher interest rates and inflation, including their consumption response to falling asset and housing prices.

“We know that consumption typically weakens as asset prices, and particularly housing prices, decline but the magnitude is difficult to forecast,” she said.

Bullock also reminded that despite recent falls, “housing prices still remain substantially above their level prior to the pandemic.”

The final uncertainty is around energy and other supply shocks that could boost inflation and lower growth. In this context, Bullock said that the RBA has built a large increase in electricity prices into its central scenario but “there is a risk we haven’t incorporated enough.”

--Contact: Sophia@centralbankintel.com