How important are inflation expectations?

They are ‘just a self-fuelling mechanism that the expectation of higher inflation actually causes higher inflation’: Dr Adrian Saville from Genera Capital.

SIMON BROWN: I’m chatting now with Dr Adrian Saville from Genera Capital. Adrian, I appreciate the early morning. We chatted last year, about mid-year or so, around deflation. And you told me I might have to have salary cuts – which still gives me some sleepless nights.

We’re now almost on the other side of the coin. Before we get to the mechanics of it, how important are inflation expectations? When we were talking deflation, part of the trick is that if I think something’s cheaper in a year, I’ll delay buying it in an inflation environment. I imagine if I think something is more expensive in a year, do I rush out and buy my big-ticket items – and this kind of feeds into that inflation cycle?

ADRIAN SAVILLE: Simon, exactly. The expectations component is a critical aspect because it institutionalises, it bakes into the inflation arrangement, [or] what people think inflation is going to look like some period from now, six months, 12 months from now. If inflation at the moment is 5%, and I think it’s going to be 10%, then when I am contemplating wage negotiations, pricing arrangements, I’m going to set my wage expectation in anticipation of that inflation.

So expectation, what you think is coming down the line, is very often more important than what you’re seeing in the inflation print.

At this point I think it really needs to be emphasised that people are forward-looking and they do anticipate what’s coming. This is a key part of understanding inflation risk and the inflation environment.

SIMON BROWN: Yeah. Economics so much is people, and people at an individual level are relatively smart. They can look out of the window and say, “That’s going to be more expensive”.

Or what about scenarios? The social security in the US, their cost of living increase, is going to be 5.9% when it kicks in next year, which is the highest number in 40 years. That must also lead to people feeling richer, so maybe a little keener to go out there and spend. But if I go 5.9% this year, my expectation for the next year is also going to be higher, and again that just sort of feeds into it. So it’s both the sort of expectation of what my salary increase will be, but then when I get it, that feeds that loop.

ADRIAN SAVILLE: Yeah. In the world of finance and economics the behaviour here that we talk about is an attribute called ‘anchoring’: a recency bias that what has happened most recently is what you might anticipate to happen next. Among other things, you’ve got the expectation taking you higher and then it becomes a self-fulfilling prophecy. It’s just a self-fuelling mechanism that the expectation of higher inflation actually causes higher inflation.

Just to rewind to your earlier points – if you think prices are rising, will you rush out and buy stuff? Theoretically, yes. If everyone does it at the same time, then it’s a bit like a run on the bank.

If we all rush to the store in the same moment, expecting that the prices of food, cars, clothes are going to be higher or meaningfully higher later, [and that] we should buy them now, then we’re going to boost demand artificially and cause prices to go higher.

There’s so much in here that is about the way in which people behave in anticipation, and then that expectations component is absolutely critical.

SIMON BROWN: Yeah, we essentially pull forward next year’s shopping into this year. As you say, that then boosts this year’s demand, and we get inflation.

I look at the US at this point. In April we were at 4.2%, and if you go back to October, we were at 1.2% – or they were. They hit 4% in April. They’ve been above 5% since June. I mean, they’ve had five months of plus-5% inflation. Do we start to worry that this starts to get baked into the system?

ADRIAN SAVILLE: The language that’s being thrown around in policy circles is that this is ‘transitory’. I think the reason why this word is being used so much, with such frequency and emphasis, is because if we can get people to expect that this inflation is exactly that – that it’s transitory – they’ll let it go, they’ll let this one go. Yeah, it’s 5%, but it’s passing. Remember the 2% or the 3%.

The emphasis on transitory is to try and insist that, although you are seeing 5% now, this will pass, relax, it’s soon going to be over.

You make the point that we’re now starting to see a regularity of the 5% and, if that’s the case, then people will quickly be drawn out of the belief that this is transitory and they’ll start to change their belief based on the experience that, hang on, this isn’t so transitory, it most certainly is 5% and it’s sticking around. Then the flywheel of inflation is kicked in.

SIMON BROWN: I take your point on that, because I’ve noticed that the governor locally always refers to 4.5%. He never gives the 3% to 6%. He says 4.5%. I’ve always figured that, because he doesn’t even want to mention 6%, he wants that not even on the table – just don’t talk about it, have that 4.5% – he is setting expectation.

I hadn’t realised that’s exactly what [US Fed chair] Jerome Powell is doing by saying ‘transitory’. He’s not doing a number, he’s using that language to try and not hoodwink, but try and calm the population.

ADRIAN SAVILLE: Yeah. It’s to persuade us. That’s not meant in a negative or deceitful way, but to persuade us in our expectation that this is what the environment is like. So in South Africa domestically you’re absolutely right. Let’s not talk about ‘three to six [percent]’, because people will fear the worst, 6%. They’ll set their plans on that basis, or they’ll set their negotiations or pricing arrangements on that basis.

Similarly in the conversations going on in the US, in particular, this is transitory: let’s not talk about the 5%. Let’s just agree that this too shall pass.

SIMON BROWN: So is this US inflation not transitory, is it going to come through? We’ve got, as I mentioned, the social security cost-of-living increases, we’ve got oil at a multi-year high – both West Texas and Brent feeding into it. We’ve certainly got staffing challenges in the US. One way you resolve that is higher salaries and the like.

Do you think in a year’s time we’ll be talking about that transitory phrase, or in a year’s time are we talking about structurally higher inflation? Maybe not 5%, but sort of 3.5% or 4%?

ADRIAN SAVILLE: Well, why not 5%? There are so many things in the system that point to higher rather than lower inflation. Here’s an economist about to make a forecast, so let’s meet in a year and we can talk about how wrong I am.

But there are a couple of things that sit in the system that pre-load us for higher inflation – among others, the abundant printing of money and low interest rates. That spring-loads the system for inflation. The second is supply-side constraints and microprocessor shortages, as just an example, constraints in supply chains in ports, in logistics, in transit. All of that is feeding the inflation system. Energy sits in the supply chain. At the beginning of the year oil was $40 a barrel; it’s now $80-plus.

And then you’ve got demand-side factors which include, as you’ve referenced already, the social wage programme, which has encouraged spending – or ‘has helped spending’ perhaps is better. Helped rather than encouraged. So you’ve got supply, you’ve got demand, and you’ve got the money system all indicating higher and not lower prices.

SIMON BROWN: Hence why not 5%? I take your point on that – why not 5%?

We’ll leave it there. Dr Adrian Saville from Genera Capital, I always appreciate the time, I always come away smarter.

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Gigaba increased vat by 1%. We never had an issue with inflation before that.

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