Inflation and relative price variability: New evidence from survey-based measures of inflation expectations in Australia

For the first time in the literature, this paper uses survey-based measures of inflation expectations to examine the relationship between inflation and relative price variability (RPV). Using quarterly consumer price index data for 74 consumption categories in Australia from 1989 to 2014, we estimate the basic linear and piecewise liner models to investigate the impacts of expected and unexpected inflation on RPV. Both headline and core inflation measures are used. The results show a statistically significant and robust positive impact of unexpected inflation on RPV. There is little evidence of asymmetry between the effects of positive and negative inflation shocks. This paper further investigates the specific functional form of the inflation-RPV relationship. While the results suggest a J-shaped nonlinear relationship between inflation and unexpected inflation, there is little evidence of any specific functional form for an expected inflation-RPV relationship. Finally, two structural breaks in the inflation-RPV relationship are identified: 2003Q2 and 2007Q2 for headline inflation and 2000Q2 and 2006Q2 for core inflation. The first two regimes are characterized by a positive and convex association between RPV and unexpected inflation, which disappears in the third regime. The results are qualitatively similar when the model is re-estimated using standard forecast-based inflation expectation measures, suggesting that the traditional approach captures the inflation-RPV relationship reasonably well, at least for Australia.