Inflationary expectation tales

Inflationary expectation tales
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First Published: Wed, Aug 11 2010. 08 53 PM IST
Updated: Wed, Aug 11 2010. 08 53 PM IST
Inflation is a dodgy Indian story. The government, after endless rounds of big spending, keeps promising that prices will cool after two months. After two months, it promises the same thing again. The question to ask is: what do economists, private sector bankers and forecasters think about inflation? Is it going up or down and why?
The 12th round of the Survey of Professional Forecasters conducted by the Reserve Bank of India (RBI) has some interesting answers. In the second quarter of fiscal 2011 (Q2 FY11), the median forecast for inflation (based on the Wholesale Price Index, or WPI) is 9.5%. The expectation is that by the first quarter of the next fiscal (Q1 FY12), it will cool down to 6.4%. All this fits in nicely the expectations on increases in policy rates by RBI: Forecasters expect the repo rate to go up from the current 5.75% to 6.5% by Q1 FY12. The reverse repo rate is expected to head north from the current 4.5% to 5% in the same period.
A comparison of forecasts for the same period in different rounds of the survey throws up results which are more interesting. For each forecast period (Q1, Q2, Q3 FY11), every succeeding survey shows the median inflation forecast going up. For example, for Q2 FY11, the 10th-round WPI inflation forecast was 6.4%. In the 11th round, it increased to 8% and in the present survey it has gone up to 9.5%. In other words, every succeeding survey showed an upward bias in inflationary expectations.
The lesson and the cause-and-effect sequence involved are clear: Real interest rates matter a lot in anchoring inflationary expectations. This elementary lesson evokes endless controversy. It leads to a sterile debate on how an increase in interest rates will kill growth. What is evident now is that by not pushing interest rates upward, all that was achieved was the fuelling of inflationary fires. To say that inflation is a supply-side phenomenon and that monetary policy can do little to quell it ignores one key fact: Unhinged inflationary expectations may require more bitter monetary medicine at a later date. The drivers of growth in India are robust; it is inflation that should be the cause for worry.
Inflationary fires: tamed finally? Tell us at views@livemint.com
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First Published: Wed, Aug 11 2010. 08 53 PM IST