Not many people would know that Sveriges Riksbank, the central bank of Sweden, is the oldest bank in the world. Or that in 1968, it instituted the Sveriges Riksbank Prize in Economic Sciences to commemorate its 300th anniversary. Popularly known as the Nobel Prize in Economics, this prize went last year to Edmund Phelps of Columbia University for his work on the dynamics of macroeconomics over time, which in turn aligned monetary policy much more with the real world.
For long, it was considered enough to link inflation levels inversely with unemployment in the economy. Wages would rise very slowly in times of high unemployment, and inflation would, therefore, be low. Inflation would rise when unemployment was low and firms would raise wages to attract workers. But Phelps showed that such a formulation was rather simplistic since it did not account for the expectations of workers.
Since wages and prices are revised infrequently, when firms and workers do not have full knowledge and information about the future, their decisions and actions would be guided not just by current inflation levels, but also by their expectations of what is likely to happen later. If they believe that unemployment will fall and prices will rise, they would push for a rise in wages now, keeping both inflation and unemployment up, a contradiction of the previous result. Phelps’ work proved itself empirically in the 1970s, when high unemployment and inflation coexisted. That changed the very foundation for monetary policy. Influencing inflation expectations has become an integral part of monetary policy globally, as central banks grapple with the balance between growth and inflation.
In a lecture early this month, incidentally at the Riksbank, Y.V. Reddy said that measuring inflation, especially inflation expectations, is one of the emerging challenges for monetary policy. This is because “inflation processes have become highly unclear and central banks are faced with the need to recognize the importance of inflation perceptions and inflation expectations, as distinct from inflation indicators”.
Inflation as shown by the data, as perceived by firms and consumers and as expected for the future is an all-important consideration for monetary policy decisions. The low headline inflation numbers of below 4% should not, therefore, be a source of complacency. With inflationary pressures persisting, demands for higher wages and prices can be kept down if the Reserve Bank of India (RBI) can convince the public that a low inflation regime will be maintained.
We can see that firms, central banks, individuals, etc., all form their expectations “on the job”, through what is known as “adaptive learning”—they learn from experience, they learn from each other, they adapt their expectations as fresh information comes through. This process of learning is particularly tough when an economy is going through structural change, as India is right now. But it also complicates monetary policy for the central bank.
For instance, what happens when firms and individuals build up expectations that are inconsistent with the central bank view (e.g., when real estate prices go far beyond what the bank deems is acceptable for financial stability)? Research confirms that in such a situation, the central bank would act more aggressively to jolt the errant back onto the path.
Models that account for adaptive learning on the part of firms and the central bank show that there is a strong tendency to go for policies where inflation tolerance is low. For us, this would imply higher interest rates for longer than most of us would think necessary.
Managing expectations calls for credibility and transparency. Central banks have worked towards sharing data and information about the way they conduct monetary policy to increase the effectiveness of policy. When we know the rationale behind a decision, it becomes easier to anticipate a policy response later. There is also the possibility that a very credible central bank that has proved its commitment to a particular inflation target can influence expectations merely by indicating a threat to act. There will be no need for a rate hike or any active policy measure by the bank. But for this to materialize, the central bank has to have a very effective track record in maintaining price stability. For India, low inflation is a relatively new phenomenon and, with all the changes in the economy, it is as yet difficult to extract the extent to which RBI should get credit for this.
Financial stability has gained precedence over price stability and growth as the overriding concern of monetary policy in India today. But given the issues regarding inflation measurement in India, despite the low inflation data recently, RBI would presumably err on the conservative side for some more time. A rate cut, therefore, would not be on the agenda in the near future.
There are political constraints to monetary policy that have been acknowledged by Reddy in his speech, as well. So, while research has shown that firms and central banks learn, the question that remains to be answered is: Can we expect governments to learn?
Sumita Kale is chief economist at Indicus Analytics. Comments are welcome at firstname.lastname@example.org