But if that confidence weakens, the central bank may need to act more aggressively – with higher interest rates and a greater risk of slowing the economy.
Interest rate decisions are not just about current inflation data. They are also about managing expectations.
The board is really focused on inflation expectations. We’ve been able to achieve this because inflation expectations have been anchored. If we see that they are not, then interest rates are going to have to respond.
Earlier this month, Governor Michele Bullock warned “we already have elevated inflation” and there is a “risk that inflation expectations might become a little bit unanchored”.
What are inflation expectations?
This can make inflation more persistent than it would otherwise be.
Even without a wage–price spiral, inflation expectations remain a key part of the story.
What is surprising is that this rise has occurred even during periods when petrol prices were falling.
This makes a classic wage–price spiral less likely.
Keeping inflation expectations under control is crucial. If households and businesses remain confident that inflation will return to the 2–3% target range, the RBA has a much better chance of bringing inflation down gradually.
Why the RBA cares so much
One of the biggest risks for central banks is that inflation becomes embedded in people’s thinking.
In its statement, the RBA noted that “short-term measures of inflation expectations have already risen” and warned “there is a material risk that inflation will remain above target for longer than previously anticipated”.
Central banks aim to keep inflation expectations “anchored”. This means ensuring people continue to believe inflation will return to the target range over time.
Even so, the risk today is more subtle: expectations could still be drifting higher without triggering a full wage–price spiral.
If households believe prices will continue rising quickly, they may adjust their behaviour – spending sooner, accepting higher prices, or expecting stronger wage growth in the future.
Signs expectations may be rising
While much attention tends to focus on current inflation, the central bank’s latest decision on Tuesday highlights another concern: what people think inflation will be in the future.
If expectations remain anchored, temporary shocks – such as higher fuel prices caused by the Middle East war – are less likely to turn into sustained inflation. People assume inflation will settle back down, and their behaviour reflects that belief.
Economists track these beliefs in several ways. In Australia, one widely watched measure comes from the Melbourne Institute, which surveys households about their expectations for inflation over the next 12 months.
Recent data suggest inflation expectations in Australia may be edging up again.
The Melbourne Institute survey shows households’ expectations for inflation over the next year have increased in recent months.
Could inflation psychology become entrenched?
This matters, because inflation is not just about what prices are doing today. It is also shaped by what households and businesses expect prices to do in the future.
As National Australia Bank’s chief economist Sally Auld has pointed out, this suggests households remain concerned about broader price pressures, not just temporary movements in fuel costs.
For the RBA, that target is 2–3%.
After two back-to-back interest rate hikes by the Reserve Bank of Australia (RBA) in February and March, all eyes are on the next policy meeting set for May.
But if expectations begin to drift higher, the task of taming inflation becomes much harder.
That is why inflation expectations, though less visible than prices themselves, are at the centre of the RBA’s latest rate increase.
Why expectations still matter
Together, these responses can push inflation higher – even if the initial increase in prices was temporary.
If households expect prices to rise quickly, they may bring forward spending to avoid higher costs later. Businesses may increase prices in anticipation of rising input costs. Workers may seek higher wages to protect their purchasing power.
This was a defining feature of the 1970s. Workers expected prices to keep rising and demanded higher wages, while businesses raised prices to cover those costs – creating a self-reinforcing cycle known as a wage–price spiral.
Workers now generally have less bargaining power than in the 1970s. Wage negotiations are less frequent, and union membership is much lower at just 13%, down from 40% in 1992.
These expectations are not just abstract numbers. They influence real decisions.
The bottom line
Today’s economy is different in important ways.
In other words, even when some prices ease, people may still expect general inflation to remain elevated.
That is why the RBA is placing such strong emphasis on expectations. As Bullock put it:
Put simply, inflation expectations are beliefs about how quickly prices will rise over the next year or two.
