Inflation describes the process of sustained price increases for a wide range of goods and services. Thus, inflation originates from decisions by enterprises to increase the prices for their goods and services. When taking such decisions, enterprises do not only take into account the past development of prices and costs (such as wages, input prices, rents), but also their expected increase in costs and prices in the near future. In such a way, inflation expectations become a key determinant of inflation itself. This phenomenon, which also applies to wage setting, is the main culprit for the own dynamics inflation can develop through "second round effects".
This insight has deep consequences for the conducting of monetary policy and for fighting inflation in general. In order to combat inflation it is not sufficient to restrain current monetary and fiscal policy; the authorities have also to target inflation expectations and try to influence them in a positive way. Only when inflation expectations are anchored, the authorities will be able to achieve price stability. This is particularly true for the NBU as the central bank, but extends equally to other branches of government. Any measure to be implemented to fight inflation (e.g. a more restrictive social or wage policy) should be announced well in advance to impact expectations and thereby directly inflation.
But since inflation expectations are not directly observable, it is necessary to measure expectations using a certain methodology. Two main methods are frequently used: either derived from surveys (direct method) or through inflation-linked bonds (indirect method). Indirect methods cannot be implemented in Ukraine as of today, because of the non-existence of inflation-linked bonds. Consequently, the NBU will have to focus on direct methods for the time being. Concerning direct methods, there are a number of surveys for measuring inflation expectations currently in place in Ukraine. In our view, the methodology of existing surveys should be improved, as all have their own peculiarities. International experience offers some important insights for such improvements. While the sectoral coverage should be gradually broadened (stressing the importance of household respondents), also the expectations horizon need to be enlarged. While short-term expectations, as they are currently collected, are an important information indicator, also expectations over longer horizons should be collected in addition. Longer term expectations are an important element in most international surveys, as they capture the perceived credibility of the central bank, and entail therefore important additional information. Also the way such different survey data are collected, monitored and presented to the public could be improved. Here, the NBU could take the lead and conduct a comparative analysis of all available surveys and communicate the results to the public.
The present paper makes a first attempt to analyse inflation expectations on the basis of simple correlation analysis. Here, some interesting leading indicator properties of the survey performed by the IER could be identified. However, based on the improvement in methodology and the availability of longer data series, we recommend the NBU to conduct a systematic research on expectations. This includes the concrete formation mechanism, the relationship of expectations with realised inflation, and its reactions to policy actions. The results of such applied scientific research could then be used in an active manner by the NBU to anchor inflation expectations, analyse its perceived credibility and thus contribute to price stability. The future shift to inflation targeting as a monetary policy framework will likely increase the need for such measures, as central bank credibility and the management of inflation expectations are key elements in such a framework.
