Managing expectations

Sustained higher inflation can affect outlook

The global economy is facing sustained inflationary pressure at least since the start of the recovery from the pandemic-induced disruption. Large central banks, as a result, have tightened monetary policy at the fastest pace in decades, which has helped bring down the inflation rate, though it still remains above target in most jurisdictions. According to projections made by the International Monetary Fund in its latest World Economic Outlook (WEO), global inflation is expected to decline from 8.7 per cent in 2022 to 6.9 per cent in 2023, and further to 5.8 per cent in 2024. The Reserve Bank of India (RBI) also increased the policy repo rate by 250 basis points since May 2022 before pausing. The Monetary Policy Committee (MPC) of the RBI decided to extend the pause last week. According to its projections, the inflation rate in the current year is expected to average 5.4 per cent. However, potential risks — such as volatility in global food and energy prices, and El Niño conditions — can increase risks to the upside.

The outlook for central banks, including the RBI, still remains challenging, and how quickly they are able to attain the target, to an extent, will depend on how inflation expectations have shaped. As an analytical chapter in the latest WEO has underscored, inflation expectations play a key role in shaping inflation dynamics. Expectations that future inflation will rise could feed into current inflation rates, keeping them elevated for longer. In other words, central bank actions that bring expectations down could contain inflation more quickly and easily. Bringing down the inflation rate is more challenging in developing economies because they tend to have a high proportion of backward-looking economic agents who form expectations based on past experiences. Thus, episodes of high inflation in recent history feed into their expectation formation, keeping the inflation rate elevated for longer periods. Further, once the expectations get elevated, correction to the target takes more time.

The study also notes that near-term inflation expectations have a higher predictive power in explaining actual rates of inflation than long-term expectations. Notably, across developing economies, long-term expectations have remained anchored, while near-term expectations exhibit large deviations away from the inflation target. A higher share of backward-looking agents and sharply elevated near-term expectations can, thus, prolong inflation and weaken the impact of monetary policy action. Sustained inflationary episodes can complicate matters further since achieving inflation reduction over a given period would be more costly in terms of output forgone. Central banks in developing countries will naturally be in a much better position to achieve price stability if the economy has more forward-looking agents who know that supply-side or cost-push shocks are transitory in nature.

In terms of anchoring inflation expectations, as the study also highlights, the independence of central banks, and transparency in monetary policy actions and communication are critical. Improvements in the monetary policy framework can help make inflation expectations more forward-looking. In this context, India has done well to adopt a flexible inflation-targeting regime where monetary policy decisions are taken by the MPC, which also has independent members. However, the committee has struggled in recent times in reading the macroeconomic scenario and evolving inflation conditions. Things have become a bit more complicated with the recent supply-driven inflation spikes. Clear communication, uncompromising commitment to the inflation target, and readiness to act, if necessary, will be critical at this stage.