BackOpinion | The role of expectations in inflation targeting
The anchoring of inflation expectations depends upon a number of factors such as the credibility and independence of the central bank
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Many emerging market economies have adopted an inflation targeting framework (either strict or flexible) in recent decades. At the core of any inflation targeting regime is the crucial task of managing inflation expectations. In fact, the effective implementation of monetary policy under inflation targeting depends upon how well anchored the inflation expectations are. When actual inflation drifts away from the target in the short run, the crucial task before the policy is to anchor medium to long term inflation expectations around the target.
In its October 2018 World Economic Outlook, the International Monetary Fund (IMF) provides very interesting insights about the improved inflation performance of emerging markets since mid-2000, in the chapter titled “Challenges for monetary policy in emerging markets as global financial conditions normalize". The chapter concludes that domestic factors, mainly long-term inflation expectations, are the major drivers of inflation in emerging markets. The inflation expectations in emerging markets have become increasingly anchored over the past two decades. Moreover, well- anchored inflation expectations can improve the strength of the domestic economy to counter adverse external shocks, reduce inflation persistence and curtail the pass-through of exchange rate depreciation to domestic prices.
The behaviour of inflation expectations have important implications for the actual inflation outcomes and the monetary policy. Also, the extent of forward versus backward looking elements in the expectations formation actually determines the magnitude of the output loss under disinflation process (see our Mint column “The importance of inflation expectations", January 2018). Ideally, a firmly anchored medium to long term inflation expectation would not respond to temporary shocks to actual inflation and would become more stable around the target.
However, the anchoring of inflation expectations depends upon a number of factors such as the credibility and independence of the central bank, clarity and transparency in the communication of policy decisions to general public etc. Furthermore, the anchoring of inflation expectations occurs only gradually as it takes some time for the central bank to gain credibility. The inflation targeting framework put into place is expected to establish the credibility of the central bank by reducing the uncertainty about future policy actions through increased communication, transparency and predictability in the policy actions.
In India, the transition of monetary policy towards a flexible inflation targeting (FIT) framework began in early 2014 when, on the recommendations of the Urjit Patel committee report, the Reserve Bank of India (RBI) adopted a glide path of gradual disinflation in terms of consumer price index (CPI) inflation. The adoption of the FIT framework took place through the formal agreement between the government and the RBI in February 2015. The mandate of monetary policy under the FIT framework is “…to primarily maintain price stability, while keeping in mind the objective of growth".
In an emerging market economy like India, concerns about the output growth can’t be ignored completely while controlling inflation. Hence, the framework itself implies that there is flexibility to address growth concerns in the short run. However, given the mandate, the task of the policymakers is not as straightforward as it seems. When a shock (internal as well as external) hit the economy, both inflation as well as output are adversely affected. Policymakers face a dilemma of stabilizing inflation as against stabilizing output, especially when output and inflation move in opposite directions after the shock.
Under such a dilemma, inflation expectations play a crucial role. If inflation expectations over the medium to long term horizons are firmly anchored around the target, this provides some space for monetary policy to address growth concerns, even when the actual inflation spikes temporarily due to shocks. Firmly anchored inflation expectations prevent the second round effects of a relative prices changes.
What are the trajectories of inflation and inflation expectations in India over the last few years?. The RBI’s quarterly households’ inflation expectations survey provides the three months and one-year ahead inflation expectations of households. A simple analysis of the mean and median expectations of households’ expectations from these surveys indicate that the household inflation expectations were high and volatile before the adoption of FIT in 2015. However, once the formal agreement between the government and the RBI took place in 2015, inflation expectations started coming down drastically and became less volatile.
Actual inflation, which was almost around 9% in the beginning of 2014, also started declining thereafter and has stabilized around 4-5% in recent times—well within the inflation target band. However, given the declining trajectory of actual inflation, inflation expectations have remained well above the actual inflation, lying outside the upper bound of the target band. The regional variation in inflation needs to be taken care of in this context. Even though the RBI has trimmed its inflation forecasts in the recent policy meeting, it is of utmost importance that the medium to long run inflation expectations also align with those lower inflation forecasts.
Despite some credibility gained by the RBI recently, it needs to communicate its future course of actions clearly and transparently to further enhance its credibility.
The improved credibility would then help to anchor inflation expectations firmly around the predetermined 4% target. If this happens, upside risks to inflation due to depreciation of the rupee and the rising crude oil prices in recent times could be reduced.
Bhavesh Salunkhe and Anuradha Patnaik are, respectively, senior research fellow and assistant professor, at Mumbai School of Economics and Public Policy (Autonomous), University of Mumbai.
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