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How useful are RBI’s inflation surveys?

Inflation
Inflation

Summary

The RBI conducts a bimonthly survey to assess how households perceive inflation. But households tend to severely overestimate inflation. Since inflation perceptions shape decisions to spend and invest, it’s important for the surveys to hold greater meaning.

When the Reserve Bank of India (RBI) raised interest rates last year, its aim was to curb inflation. The key link in the transmission from rate hikes to lower prices is inflation expectations: households and corporates have to be convinced that inflation will be brought under control, so that they are motivated to consume and invest. To this end, the RBI conducts a bi-monthly Inflation Expectations Survey of Households (IESH), in which it asks a sample of households about their views on current and future price movements. Unfortunately, the results have not served this purpose very well.

 

Households overestimated current as well as future inflation in each survey of the last decade. Their inflation estimates were always higher than 6%, though actual inflation was largely within the 2-6% range. That’s because households are very sensitive to changes in prices of essential, frequently-purchased goods such as petrol, vegetables, or foodgrains. For example, a 10% hike in petrol price results in the view that inflation is 10%, though the overall impact on the monthly household budget may be lower. Thus, households quickly raise inflation expectations when there is an increase in prices of daily-use items, but are slow to revise it downward, and cautious about adjusting it too far down.

Due to this upward bias, household expectations are not very useful in forecasting inflation. Surveys of professionals or businesses do a much better job. However, the data provides some interesting insights into how households form perceptions, and how they respond to price shocks.

Financial Literacy

Median inflation expectations fell slightly in 2022-23. But dig deeper, and we see a qualitative worsening. Across ages, occupations, and genders, the percentage of respondents expecting prices to increase at the same or a higher rate has increased. That’s because households tend to be backward-looking and focus on the recent past while predicting inflation. (Inflation was higher in 2022-23.) Expectations of homemakers have worsened, probably because household budgets were badly impacted by the Ukraine war. Daily-wage workers and the self-employed likely factored in greater uncertainty in real incomes. Only financial sector employees were more optimistic—perhaps because they better understand of inflation and monetary policy. This suggests a need to improve “inflation literacy" if these surveys have to inform policy. This can be achieved by communicating the causes of inflation and the role of RBI policy actions clearly and simply.

Consumption Link

High inflation expectations create uncertainty about future real incomes. Households respond by increasing precautionary savings and cutting back on non-essential spending. Mapping IESH data to the RBI’s Consumer Confidence Survey brings out the negative link between inflation expectations and consumption. The link is especially strong during high inflation periods. For example, inflation expectations soared after December 2012 as fuel and vegetable prices increased. In response, the percentage of households expecting to spend on durable goods dropped steeply. As the price situation improved, inflation expectations eased, and consumer confidence picked up. A similar pattern was seen during May-December 2021, when a series of petrol price hikes pushed up inflation expectations, discouraging spending on non-essential goods. Deeper insights can be obtained by adding more demographic details to consumption surveys.

Anchored to 10%?

If households’ inflation expectations remain anchored during high inflation periods, it shows that monetary policy is effective. But the IESH shows mixed results. Even in normal years, inflation expectations cluster around 10-11%, much beyond the RBI target of 4%. Naturally, when inflation is high, households build on this high base to express even higher expectations. For instance, the share of households expecting one-year-ahead inflation to be over 16% rose from 22.5% in March 2021, to 30.5% in September 2022 as actual inflation rose. But this was restored to 22.8% by March 2023. The good news is that the reaction to price shocks was temporary. This is a testament to the RBI’s credibility. The bad news is that a significant proportion of households perceive inflation, both current and future, to be well above the 2-6% range. Fixing this issue would greatly improve the usefulness of expectations data.

The author is an independent writer in economics and finance.

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