Households Tend To Pay More Attention To Inflation When It Is High - Analytical Note

Inflation expectations - what people think inflation will be in the future – are crucial for policymakers at the Reserve Bank of New Zealand, Te Pūtea Matua.

That’s because these expectations affect everybody’s decisions about savings, spending, and how much of a wage increase they may ask for. If people expect inflation to be high in future, they’ll likely ask for higher wages.

On the other hand, firms set their prices depending on their outlook for inflation and wage levels.

So individual workers and businesses views of expected inflation influence overall inflation.

In a newly published Analytical Note, Senior Economic Analyst Gerelmaa Bayarmagnai looked at how New Zealand households’ inflation expectations respond to changing prices - what inflation is now and how that shapes what people think it will be in future.

The Note found that household inflation expectations are more sensitive to inflation when it goes above 2 to 2.5 percent. This means that households care less about inflation when it is low and pay more attention when inflation is high, and it is affecting their cost of living.

Inflation expectations line up better with actual inflation when it is high, and so expectations may respond less to interest rate policy signalling. This may make it more difficult for policymakers to keep inflation expectations down when inflation is high.

More information:

Rational Inattention to Inflation among New Zealand households -

Analytical Note

.

Author: Gerelmaa Bayarmagnai

Key findings

• This Note presents empirical evidence suggesting that New Zealand households tend to pay more attention to inflation when it is high, than when it is low. In the academic literature, this is known as ‘rational inattention’.
• Rational inattention can result in a non-linear relationship between actual inflation and households’ inflation expectations. Once inflation rate rises above a certain threshold, for example, 2%, household inflation expectations line up closely with actual inflation. Thus, inflation expectations may be slow to respond to monetary policy announcements, and this may make it more difficult for the central bank to rein in high inflation by raising interest rates.
• It is important for monetary policymakers to monitor this potential non-linearity in how households perceive and internalise inflation data.

The

Analytical Notes

series encompasses a range of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

Why we did this research

Inflation expectations- what people think inflation will be in a year or several years from now- play a vital role in driving actual inflation. Hence, well-anchored inflation expectations are often seen as a sign of the credibility of inflation-targeting monetary policy. The Reserve Bank of New Zealand closely monitors how people think prices will change in the future and aims to manage these expectations.

The Monetary Policy Remit outlines the goals of monetary policy for:

• medium-term price stability
• maximum sustainable employment
• soundness of the financial system
• avoiding unnecessary instability in output, interest rates and the exchange rate.

This Analytical Note is also in line with our Statement of Intent.

What data have we used?

We used responses from the Household Expectations Survey, a quarterly survey of what households expect regarding future price movement. The survey usually includes responses from 1,000 residents in New Zealand.

Read more about the survey here.

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