Can monetary policy and, in particular, inflation targeting lead to lower inflation expectations?
Reserve Bank of India (RBI) governor Raghuram Rajan has repeatedly underlined the importance of managing inflation expectations. Without too much exaggeration, we could say that anchoring inflation expectations of households at a low level lay at the heart of his monetary policy.
For instance, in December 2014, when he kept the repo rate unchanged at a high 8%, he said, “if the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle". The chart shows median household expectations in December 2014 was at 8.5% three months ahead and 8.9% a year later.
Sticking to his promise, Rajan started cutting interest rates in January 2015. In his statement, he said, “Households’ inflation expectations have adapted and both near-term and long-term inflationary expectations have eased to single digits for the first time since September 2009."
In June this year, when the repo rate was cut to 7.25%, Rajan noted, “Inflation expectations remain in high single digits, although they may adapt further to current low inflation." In August, RBI decided to leave interest rates unchanged. In his policy statement, he sounded this warning: “Some food prices, particularly of protein-rich items, pulses and oilseeds have risen sharply in recent months. They will have to be carefully monitored as they tend to be sticky and impart an upward bias to inflation and inflation expectations. This assumes significance in view of households’ inflation expectations rising again." As the chart shows, median household inflation expectations had risen in June 2015 to 10.1% and 10.3% for the three-month forward and one-year ahead forecasts, respectively.
In September, household inflation expectations showed another rise, to 10.5% for the three-months ahead period and 10.8% for the one-year ahead forecast. And yet, this time, Rajan cut the repo rate by 50 basis points from 7.25% to 6.75%. One basis point is one-hundredth of a percentage point. In his statement, these survey results were dismissed with the line, “Inflation expectations of households remained elevated in double digits, likely in response to recent month-on-month increases in the prices of vegetables and pulses." The concern with the rising prices of pulses so evident in the August statement seems to have disappeared.
In short, as the chart shows, between December 2014 and September 2015, the median inflation expectation of households for the three-month ahead period has gone up by 2.2 percentage points, while the one-year ahead inflation expectation is up by 1.9 percentage points. But, over the same period, the repo rate has been cut by 1.25 percentage points, from 8% to 6.75%.
The obvious question is whether RBI has decided not to bother too much with the inflation expectations of households and focus on the actual inflation trajectory instead. After all, consumer price inflation has fallen substantially from the levels it was at a year ago and, yet, household inflation expectations don’t seem to reflect that. That holds true for food inflation, too, which affects household inflation expectations to a substantial degree. Household inflation estimates have consistently been much higher than actual inflation. But at the same time, inflationary expectations do affect inflation—if expected inflation is persistently high, workers will demand higher wages, businesses will believe they can pass on higher prices.
Of course, RBI considers many other factors apart from household inflation expectations in its interest rate decisions. In view of substantial spare capacity in industry, the absence of pricing power by firms and the likelihood of commodity and oil prices remaining low for a long time, RBI was justified in cutting rates sharply last week.
The larger question is: can monetary policy and, in particular, inflation targeting lead to lower inflation expectations? The title of a recent research paper by Saten Kumar of Auckland University of Technology; Hassan Afrouzi and Olivier Coibion of University of Texas at Austin, and Yuriy Gorodnichenko of University of California at Berkeley says it all: Inflation Targeting Does Not Anchor Inflation Expectations: Evidence from firms in New Zealand.
That is bad news for central bankers, who believe in their ability to manage inflation expectations. The paper says, “Despite 25 years of inflation targeting in New Zealand, managers of firms there have been forecasting much higher levels of inflation than has actually occurred, at both short-run horizons and very long-run horizons. Their average perception of recent inflation is also systematically much higher than actual inflation. There is tremendous disagreement in the forecasts of firms, at all horizons, as well as disagreement about recent inflation dynamics." And if this is the conclusion a survey of the managers of firms arrives at, what horrors will a survey of households unearth?
The paper reaches the same conclusion about the US: “Despite dramatic changes in the communications strategy of the Federal Reserve over the last 20 years, the US general public appears to remain profoundly uncertain about what exactly the Federal Reserve does."
Perhaps, it’s just as well the Reserve Bank of India has decided not to be obsessed about high household inflation expectations.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com
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