BackThe neglected role of growth expectations
The central bank’s mandate is to consider not just inflation but also growth
Premium(Pradeep Gaur/Mint)
Inflationary expectations are pernicious things. If people believe that inflation will remain high in the future, they will adjust their behaviour to reflect that belief. If, for example, workers in a factory think that the rise in prices for the next year will be around 10%, their union will aim for a wage increase of more than 10%. If you think that house prices are going to go up in future, you will try and buy a house as soon as you can. This change in behaviour could mean that the expectations of high inflation become self-fulfilling. The increase in wages, for instance, will lead to a rise in demand and may therefore result in higher prices, which again triggers agitation for higher wages, leading to a wage-price spiral.
Small wonder then that containing inflationary expectations is at the top of the to-do list for the Reserve Bank of India (RBI). The current fiscal year’s second quarter review of monetary policy says, “Managing inflation and inflation expectations must remain the primary focus of monetary policy." It further states that the stance of monetary policy is intended to “maintain an interest rate environment to contain inflation and anchor inflation expectations". And, in the first quarter review of monetary policy, the Reserve Bank governor pointed out that the non-food manufactured products inflation had not declined to the extent warranted by the growth moderation. He said this reflected “severe supply constraints and entrenchment of inflation expectations".
The problem is how to gauge inflation expectations. RBI conducts a survey of households to find out what people are thinking about future inflation. The survey shows that inflationary expectations have consistently remained in the double digits. The last survey, conducted in September 2012, shows that people think that the mean inflation rate a year ahead would be 12.7%, well above their expectations about the rate three months ahead. There has been a lowering of expectations for the current and near-term inflation rates in the September survey, but the long-term inflation expectation remains high. Perhaps this is due to the fact that we have had high inflation for a long time now and efforts to bring it down have been only partially successful so far. That has probably led to inflationary expectations becoming entrenched.
People tend to extrapolate past trends and a theory known as the adaptive expectations model says that people take time to adapt to a new inflation environment. For instance, when inflation accelerated in the early seventies as a result of the oil shock, forecasts of future inflation were consistently lower than the actual inflation rate. At present, the concern about high inflation expectations becoming anchored seems to have held back RBI from reducing its policy rate, even though it agrees that current growth is well below trend. The mid-quarter monetary policy review last month stated that, “On the domestic front, there are some incipient signs of pick-up though growth remains significantly below its recent trend."
But RBI’s mandate is to consider not just inflation but also growth. While the emphasis on inflationary expectations is justified, what about growth expectations? Expectations about future economic growth play a significant part in making that growth possible. As Keynes put it, “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." That’s easily seen in the stock markets, where sentiment is often a key driver. A market riding on optimism allows companies to raise money, repair balance sheets and expand capacity, often bringing about the growth it hopes for.
But the converse is also true. A continuous period of low or falling growth results in firms losing faith in the future. They start believing that growth will remain depressed and scale back their projections of demand. That, in turn, leads to low investment, which holds back higher growth. Confidence in the future is shaken.
RBI does have a Business Expectations Index, which, in the July-September 2012 quarter, reached a very low level seen at the onset of the financial crisis. The outlook for the December quarter was only marginally better. That doesn’t seem to have affected RBI’s policy though. Perhaps a clear example of how growth expectations have been ratcheted down is seen from Prime Minister Manmohan Singh’s recent statement that an 8% growth rate for the 2012-17 five-year plan is an ambitious target.
This is not to argue that the Reserve Bank of India was wrong in making fighting inflation its top priority. But it is also true that while the role of inflationary expectations has held centre-stage, the role of growth expectations has been largely ignored. There have been no theories about the need to anchor growth expectations, no discussion about the insidious effects of low growth expectations. In a country where we need a gross domestic product (GDP) growth rate of over 7% merely to absorb new entrants into the labour force, such an omission has serious consequences.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at
capitalaccount@livemint.com
Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!
