For the RBI, managing households' inflation expectations is critical, too

The consumer price index-based inflation rate in June declined to 2.1 per cent, considerably below the Reserve Bank of India’s (RBI’s) legally mandated target of 4 per cent. Anticipating a decline in the inflation rate, the Monetary Policy Committee (MPC) in its June meeting decided to frontload the policy intervention and reduced the policy repo rate by 50 basis points to 5.5 per cent. Several economists are of the view that the inflation rate will remain soft in the coming months and are debating whether the MPC should further reduce the policy rate. From a policy perspective, while it is important what economists and professional forecasters think, central bankers pay considerable attention to household inflation expectations as well. A new research article by RBI economists, published in its latest Monthly Bulletin, tracks household inflation expectations and emerging trends. Some of its findings are worth discussing here.

 

It is now well known that expectations significantly affect economic outcomes. Therefore, central banks focus a great deal on managing inflation expectations. For instance, if inflation expectations are not well anchored, a spike in the inflation rate could get generalised more easily, making the central bank’s job more difficult, potentially leading to higher output loss because of higher policy rates. Thus, anchoring expectations is a critical element in ensuring price stability. As the paper notes, unlike professional forecasters, household inflation expectations are formed by experience and are susceptible to fluctuations. Importantly, the study, which has used data from the RBI’s Inflation Expectations Survey of Households, found a decline in inflation expectations from the highs of 2014, helped by the shift to the flexible inflation targeting (FIT) regime, timely policy intervention, and easing of global pressures.

 

The decline in inflation expectations suggests that households are more comfortable with a rule-based policy regime. Since the target is well known, and if households believe that the central banks will work to align inflation outcomes with the target, it will help maintain price stability. The study also shows that expectations are more aligned with the headline inflation rate and not with the food inflation rate. However, expectations remain elevated during broadbased food inflation. Interestingly, women do not show a consistent upward bias. However, individuals above the age of 45 report higher expectations, which reflects their experience.

 

From the policy perspective, the paper arrives at some important conclusions. As mentioned above, the shift to FIT has had a positive impact on expectations. However, it has also been helped by supply-side intervention by the government, such as export bans. Although such steps help contain inflation, they have costs for producers, which are not appropriately accounted for in policymaking. Further, high food inflation at the time of higher overall inflation can keep expectations elevated. This also reflects the higher share of food items in the consumption basket. The study also shows that  it is important to target headline inflation to manage expectations and improve welfare. There has been considerable debate on the target since the adoption of FIT. Several economists have argued that since monetary policy has a limited impact on food prices, which are often subject to supply shocks, the RBI should target core inflation. However, households look at the headline rate and removing a critical component could affect policymaking and expectations, with implications for overall price stability and longer-term growth.