Influence of inflation expectations on the future economic landscape
Inflation expectations play a crucial yet often understated role in shaping a nation’s economic outlook.These expectations reflect the degree to which consumers, businesses, investors, and policymakers believe prices will rise in the future.
Factors Influencing Inflation Expectations
Several elements influence these expectations, including past inflation trends, current economic conditions, central bank policies, and broader economic forecasts.
- Consumer Behavior: When consumers expect prices to rise, they tend to spend more in the present rather than delaying purchases. This increase in demand can drive up inflation. Conversely, if they anticipate falling prices, they might delay spending, which can reduce demand and potentially lead to lower inflation or deflation.
- Wage Negotiations: Inflation expectations significantly impact wage negotiations. When workers expect prices to rise rapidly, they often demand increased wages to offset the decline in their purchasing power. This increase in wages raises production costs for businesses, which might then increase prices, perpetuating a cycle of inflation.
- Business Strategies: Businesses also consider inflation expectations in their pricing strategies. If they foresee rising inflation, they might increase prices preemptively to protect profit margins, contributing further to the inflation rate.
Central Bank Policies and Inflation Expectations
Central banks, such as the US Federal Reserve, use inflation expectations as a key indicator for setting monetary policy.
Setting Interest Rates
- Rising Expectations: If inflation expectations rise, central banks might increase interest rates to curb economic activity and control inflation.
- Low Expectations: Conversely, if inflation expectations are low, central banks might lower interest rates to stimulate spending and investment.
Impact on Investors
Investors consider inflation expectations when deciding where to allocate their funds. Higher expected inflation can drive investment in assets that hedge against inflation, such as real estate or commodities, whereas lower expectations might boost interest in fixed-income securities.
Bond Yields: Inflation expectations also influence bond yields and financial markets. Higher expected inflation usually results in higher bond yields, increasing borrowing costs and potentially slowing economic growth.
The Role of Central Bank Credibility
The credibility of central banks significantly depends on their ability to manage inflation expectations. Consistently maintaining inflation near the target helps anchor expectations, making it easier for the central bank to achieve its objectives with less aggressive policy measures.
Volatile Economic Conditions
If inflation expectations become unanchored, it could lead to more volatile economic conditions, necessitating more drastic interventions by central banks.
Inflation Expectations in South Africa
In 2001, the South African Reserve Bank (SARB) initiated a quarterly survey, conducted by the Bureau for Economic Research (BER), to assess inflation expectations and related economic factors. The survey encompasses the viewpoints of analysts, businesses, trade unions, and households. Each group offers a unique perspective on inflation.
The Importance of Surveys
The SARB’s Monetary Policy Committee (MPC) utilizes the survey results, among other factors, to inform its interest rate decisions.
- Rising Expectations: If inflation expectations rise significantly above the midpoint of the SARB’s 3 to 6% target range, or if other inflation indicators worsen, the MPC becomes concerned. For example, rising inflation expectations could lead to higher wage demands as workers seek compensation for anticipated higher future inflation. Similarly, businesses might increase their prices if demand is strong.
- Preventive Measures: To prevent inflation expectations from escalating into higher inflation, the SARB may adopt a contractionary monetary policy, which typically involves increasing interest rates. Conversely, if inflation expectations and related indicators moderate, the SARB may implement an expansionary monetary policy, potentially by reducing interest rates.
Recent Trends in Inflation Expectations
The 2Q24 BER survey of inflation expectations reveals that in South Africa, the expectations have gradually started to decline.
Decreasing Expectations
- Overall Trends: In 2Q24, average inflation expectations for 2025 and 2026 decreased by 0.3%, settling at 5.0% and 4.9%, respectively. All social groups reported lower inflation expectations during the quarter, with labor unions showing the most significant improvement. Their expectations for 2025 and 2026 dropped sharply by 0.6 percentage points to 5.0% and 4.8%, respectively.
- Business and Analyst Views: The expectations from businesses decreased modestly, remaining at 5.4% for 2025 and 5.3% for 2026. Analysts’ expectations also fell slightly, making them the only group to anticipate inflation reaching the midpoint of the SARB’s target range within the next two years.
Long-Term Expectations
Notably, average long-term (5-year) inflation expectations further softened, dropping 0.4 percentage points to 4.9%, marking the first reading below 5.0% since 2021.
Furthermore, on average, the various survey respondents lowered their forecast of the increase in salaries and wages in 2024 and 2025.
Expectations are now for wages to rise by 4.9% in both years, compared to expectations of slightly above 5% previously.
Implications for Monetary Policy
The continued easing of inflation expectations is a positive development for the SARB MPC before its meeting on Thursday, July 18. However, the MPC might remain concerned that the expectations of businesses and labor unions, which play a significant role in price formation, remain in the upper half of the target range over the longer term.
Future Interest Rate Decisions
We anticipate that the MPC will keep the repo rate unchanged next week. The central bank has remained steadfast in communicating that it will not move the policy rate lower until inflation is under control and sustainably hitting the target.
Potential Rate Cuts: We foresee potential rate cuts materializing towards the end of 2024, depending on the inflation outlook (locally and abroad) and global interest rate developments. At this stage, we expect an initial rate cut of 25 basis points in November, followed by further cuts totaling 50 to 75 basis points in 2025 and leading into 2026.
Conclusion
Inflation expectations are a critical factor in shaping the economic landscape. They influence consumer behavior, wage negotiations, business strategies, central bank policies, and investor decisions. In South Africa, the SARB closely monitors these expectations through surveys and adjusts its monetary policies accordingly.
The recent decline in inflation expectations is a positive sign, suggesting potential rate cuts in the near future, provided that inflation remains under control. Understanding and managing these expectations are key to maintaining economic stability and achieving long-term economic goals.
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