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Business News/ Opinion / Columns/  RBI may need a revised strategy to anchor inflation expectations

RBI may need a revised strategy to anchor inflation expectations

Patterns of household expectations of price rise are indicative of a need for better communication

The central bank’s job of managing inflation, thus, becomes harder if inflation expectations are not stable—or not anchored—around its inflation target. (HT)Premium
The central bank’s job of managing inflation, thus, becomes harder if inflation expectations are not stable—or not anchored—around its inflation target. (HT)

The world is struggling with higher-than-desirable inflation. Central banks are raising interest rates aggressively. But the battle to rein in inflation is not merely about central bank policy instruments. It is also about what we as consumers expect. And what we expect can make all the difference to macroeconomic outcomes. How does this work? What does it mean for central bank policy? What is the evidence on Indian consumers’ price perceptions?

Consumer behaviour partly depends on what people believe future product prices would be. If they expect prices to rise fast, they might buy more today, for example, raising current inflation even more. Households may also change their saving preferences away from low-risk assets such as bank deposits. Workers may demand higher wages, potentially leading to a wage-price spiral.

The central bank’s job of managing inflation, thus, becomes harder if inflation expectations are not stable—or not anchored—around its inflation target. In such cases, a short spell of high inflation can result in households marking up their perception of future inflation.

This makes it more challenging for the central bank to meet its inflation mandate. The interest rate hikes required to bring down inflation to its target level would then be higher, which could further cramp economic growth.

Household inflation expectations, thus, form a critical piece of information for central banks, especially in periods of high inflation.

For example, retail inflation in the US in September was 8.2%. The median one-year-ahead household inflation expectation was lower at 5.4% in September. The three-year-ahead inflation expectation was even lower at 2.9%, only about 1% higher than the US inflation target. In effect, currently the American people, by and large, seem to believe that the current period of high US inflation is not likely to last for too long.

In India, the Reserve Bank of India (RBI) projects retail inflation for the 12 months to March 2023 at 6.7%. The upper cap for its inflation target is 6%. RBI expects retail inflation to fall to 5% by April-June 2023. Professional forecasters, too, expect India’s retail inflation to fall next year. Urban households, however, do not agree.

Indian households expect domestic retail inflation to continue rising, as per RBI’s latest bi-monthly Households’ Inflation Expectation Survey. The median household inflation expectation for September 2023 is now 11%.

Respondents in Ranchi, Jharkhand, expect retail inflation one year ahead at 8.1%, the lowest among 19 cities surveyed. People in Bengaluru, India’s IT hub and capital of Karnataka, have the highest inflation expectation of 13.5%.

India releases retail inflation for rural and urban regions. We compared inflation expectations of urban households over time with the actual consumer inflation in urban areas, starting with 2016, when RBI moved to the current inflation-targeting framework.

First, household inflation expectations have always been higher than actual inflation since 2016. Second, they have never fallen below the upper limit of RBI’s inflation target of 6%. Such a pattern of household inflation expectations would be of concern. Third, household inflation expectations align closely with their perception of current inflation. Fourth, households do not seem to update their perceptions much when new data becomes available. For example, in July 2021, the median household inflation expectation for a year ahead was 11.5%. When RBI did the survey a year later in July 2022, the median expectation for the same month was still at 9.3%. This is despite retail inflation during the previous 12 months being much lower, between 4.6% and 7.3%.

Despite a difference in household inflation perceptions and actual inflation, the trend of actual inflation is in line with that of household inflation perceptions in the same period.

To improve the survey’s usefulness, it would be worthwhile to understand the sources of recency bias in the household reporting of inflation perceptions. Households may be unable to recall prices a year earlier and then calculate mentally how much the price rise has been during the year they report inflation expectations for the current month.

Also, household consumption baskets differ. Their expectations may reflect price perceptions of their consumption basket rather than the overall consumer price index, as RBI notes. But this is not an issue specific to India.

Whether and how variations in household inflation expectations based on age, region and occupation matter for actual inflation also merits deeper investigation. Younger survey respondents (under 25 years) tend to have the lowest inflation expectations, while older respondents (60 plus ) have the highest. Daily workers report higher inflation expectations, perhaps influenced by the prices of food products.

Public awareness of economic conditions, inflation measurement and data releases plus a better understanding of RBI’s policymaking and track record on inflation would help households assess their perceptions of future price changes better. And the pattern so far of household inflation expectations calls for a rethink of RBI’s communication strategy vis-a-vis the general public.

Vidya Mahambare & Praveen Kumar are, respectively, a professor of economics and director (research), and graduate of Great Lakes Institute of Management, Chennai.

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Published: 19 Oct 2022, 10:37 PM IST
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