Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Opinion | India needs more accurate inflation measurement

A better and more realistic measure than the current headline inflation is needed to improve monetary policy

Inflation dynamics are complex and depend to a large extent on expectations of inflation. Central banks the world over, including the Reserve Bank of India (RBI), factor in such inflationary expectations when carrying out inflation assessment for purposes of monetary policy formulation.

However, such inflationary expectations have to be well-anchored for these to be used as key indicators of credible monetary policies. As a recent paper by Ken Miyajima and James Yetman has pointed out, the source of such forecasts—whether from financial analysts, professional forecasters, general public or from businesses and trade unions actively engaged in wage negotiations—is important in credible monetary policy formulation. Inflationary expectations, however, are heterogenous across these different groups.

Other studies from the rest of the world corroborate such heterogeneity in inflationary expectations. They find that while the expectations of financial analysts and professional forecasters lie within the central bank’s target range, those of businesses, trade unions and households lie consistently above the upper end of the target range.

Why do inflationary expectations vary among groups? Less affluent households exhibit less than rational forecasts and overestimate inflation outcomes probably because they often face higher inflation than their more affluent counterparts. Similarly, businesses and trade unions tend to be more backward-looking than analysts and form their expectations based on the growth rate of wages, which normally exceeds the average inflation rate. On the other hand, analysts are far more attentive to inflation developments and incorporate these into expectations formation.

RBI, in its sixth bimonthly monetary policy for 2018-19, cut the repo rate by 25 basis points, and also voted to shift the monetary policy stance from calibrated tightening to neutral. The assessment of inflation was based on the global and domestic economic outlook, crude oil prices, etc. It was also based on headline inflation figures, and household inflationary expectations. RBI cited retail inflation, which was at the lowest in the last 18 months in December, and the softening of household inflationary expectations in its December survey as shaping its outlook.

Three questions arise. One, what were the inflationary expectations of Indian households compared to actual inflation, and were there variations among different groups? Two, given the heterogeneity of inflationary expectations among different agents, how should we assess the reported softening in household inflationary expectations? Three, what are the implications of these findings for monetary policy, especially rate cuts?

A detailed perusal of RBI’s household inflation expectations survey sheds light on the anomalies in inflationary expectations in India. Against the actual inflation rate of 2.2% in December, the perception of the current median inflation was at a high 7.1% that month. The perception of three months’ ahead median inflation was 8.2% and that of one year ahead was 8.5%. This was in variance with RBI’s inflation outlook at 3.2-3.4% for the first half of 2019-20 and 3.9% for the third quarter of 2019-20.

Further, these forecasts are different among economic agents. Thus, the current median inflation expectations among financial sector employees, homemakers and retired persons was 7.2%, 7.3% and 7.8%, respectively, while the three month ahead forecasts were 8.1%, 8.6% and 8.9%. Similarly, there was a gender-based variation, with female inflationary expectations surpassing those of male respondents.

More interestingly, of the 5,828 urban respondents surveyed, while a big chunk of them (43%) perceived inflation to be currently between 5% and 6%, 92% expected that the inflation rate three months ahead would be equal to or greater than those levels (table 4a, Household Inflation Expectations Survey)—that is, surpass the current perception. Similarly, 82% expected inflation to be higher than the current perceived level of 5-6% even one year ahead.

It is important to note that the inflation expectations survey covered only urban households. The actual inflation across most categories in December (except food and clothing and housing components) was higher for households in rural India than in urban regions. In particular, miscellaneous inflation (in the services category) for rural India was as high as 7.51%. Such high inflation numbers would affect inflationary expectations of rural households as well, which are currently not captured. While inflationary expectations of other economic agents, especially businesses and trade unions, are also not estimated currently, RBI’s other surveys indicate that both consumers and manufacturing companies in India are pessimistic about the price situation.

Thus, the current assessment of inflationary expectations in India has important omissions, notably those of rural households, businesses and trade unions. Further, there are anomalies in the form of irrational forecasts above the official target range. The groups demonstrating these anomalies, as also those omitted are important since they drive the inflation process itself, and not just future inflation.

The implication for monetary policy is clear. Improved anchoring of inflationary expectations of all groups which directly impact inflation outcomes is critical. This, in turn, would require a better and more realistic nominal anchor than the current headline inflation, greater central bank communication, increased labour market flexibility and other structural reforms aimed at increasing competition.

Tulsi Jayakumar is professor of economics at the S.P. Jain Institute of Management & Research, Mumbai.

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