BackMeasuring inflation expectations
Measuring inflation expectations
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Is the Reserve Bank of India (RBI) doing enough to offset inflationary pressures in the economy? That’s a topic that fuels endless debate among economists. Some argue that the central bank is “behind the curve"; others say it’s not doing enough. Some say there’s little RBI can do, given the fact that much of the rise in prices is due to supply-side factors; others say that even then the central bank has a role to play. But everybody is agreed that central banks across the world must act to prevent inflationary expectation from rising. That begs the question: What determines inflationary expectations? Michael Patra and Partha Ray address this question empirically in the Indian context.
They point out that regardless of whether inflation is initiated by higher food prices, monetary policy has a role to play if inflation fears get embedded in expectations. Thus, the key to the setting of forward-looking monetary policy is an adequate measure of inflation expectations.
The authors have adopted a model-based approach to generating inflation expectations. They find that lagged inflation, changes in fuel and primary articles prices and the output gap are the main determinants, followed by the real interest rate. Lagged inflation refers to the past trend in inflation and the study finds that this contributes almost 50% to explaining the formation of inflationary expectations.
That’s rather intuitive, since people’s expectation of future inflation will obviously be coloured to a large extent on the inflation they have experienced in the recent past.
This conclusion does, however, have an interesting corollary. The researchers point out that this is indicative of a “high degree of inertia or persistence". In other words, even if inflation starts coming down, inflationary expectations will remain elevated for a long time. The implication is that monetary policy must be pre-emptive, so that the central bank stays ahead of the inflation curve.
In India, changes in food and fuel prices account for 40% of variation in inflation expectations. The authors go on to make the assertion that, “Moreover, shocks delivered by food prices on the overall level of prices are relatively slow in reverting to mean. In our view, therefore, the argument that the current phase of inflationary pressures is essentially a supply-side phenomenon and monetary policy has little to do or can do little is overwhelmed by the clear and present danger of inflation expectations coming unhinged and taking on a lasting levitation." Though the paper refers to the inflation situation in March 2010, its conclusions are equally relevant today.
The researchers also find that the real interest rate, or nominal interest rate less anticipated inflation, has a significant effect on people’s anticipations, outweighing the effects of fiscal policy or even exchange rate changes. Accordingly, say the authors, “the stock monetary policy response would need to be in terms of calibrated increases in policy rates, as mentioned earlier, with a readiness to stay ahead of the inflation curve so that real policy tightening is achieved". Currently, the repo rate is at 5.5% and most economists believe that wholesale price inflation by end-March 2011 is likely to be in the range of 6-7%. In other words, the real policy rate is still negative. If this paper’s conclusions are correct, that calls for further tightening by RBI to curb inflationary expectations.
Write to simplyeconomics@livemint.com
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