For the common man, the word inflation conjures up images of rising food prices and petrol, among other things, and the general belief that inflation lowers their standard of living and slows the rate of economic growth. While it is true that high and persistent inflation quickly erodes the purchasing power of money, it is actually the rising inflation expectations that cause a slowdown in the economy. The biggest component of the cost of production?the wages and salaries paid to workers?increases with a rise in inflation expectations as the workers demand a higher compensation package. This rise in production costs lowers profit margins and slows down new investment, resulting in economic slowdown. In addition, unexpected inflation also results in arbitrary redistribution of purchasing power. While expected inflation is accounted for in the nominal interest rate at the time of a loan, unexpected inflation is not. If inflation is unexpectedly low, then it benefits the lenders at the expense of borrowers as the real cost of borrowing turns out to be higher than what was expected at the time the loan was made.

Figure 1 plots the quarterly values of inflation calculated as the growth rate in the wholesale price index over the past year along with inflation expectations. The Reserve Bank of India (RBI) conducts a survey each quarter to measure these inflation expectations of households for the current quarter, the following quarter and the year ahead. One can note that inflation expectations for the current quarter and three months ahead have come out to be persistently higher than actual inflation. Starting Q3-2010, even the one-year-ahead inflation expectations have been higher than actual inflation. This, therefore, implies that the real cost of borrowing has been unexpectedly high for borrowers taking loans up to a period of one year. For instance, money borrowed in Q4-2009 for a period of one year at a hypothetical 15% nominal interest p.a., under one-year-ahead inflation expectations of approximately 12% p.a., implies an expected real cost of borrowing of about 3% p.a. However, the actual rate of inflation in Q4-2010 turned out to be approximately only 9% p.a., as a result of which the actual real cost of borrowing became 6% p.a.?twice as much as expected. Instances like this cause an unexpected increase in the cost of borrowing and make borrowing unfavourable, thereby becoming one of many possible factors contributing to low investment and, consequently, an economic slowdown.

The fact that inflation expectations have not subsided and continue to be higher than actual inflation despite the 350 bps increase in the repo rate since March 2010 indicates the lack of faith of economic agents in RBI?s stated objective of maintaining stable prices. This is a cause for concern, and the central bank has to blame itself for its portrayal as an inflation dove. Figure 2 plots inflation and the growth rate in industrial production on the primary axis and RBI?s response as measured by the repo rate on the secondary axis. Since mid-2009, the rise in industrial production and the resilience of the Indian economy to the global recession, on the back of a strong consumption base and low dependence on global trade, has led to inflationary pressures in the economy. Whether these inflationary pressures are demand side or supply side is a matter of debate. There seems little to no ambiguity, however, that demand remains high relative to supply. Furthermore, RBI?s inaction during this period, as seen from stable repo rates from Q2-2009 to Q1-2010, can be held responsible for fuelling higher inflationary expectations. High inflationary expectations become a self-fulfilling prophecy and add to the rise in prices as discussed earlier.

If inflation expectations do not subside, then people look to divert their savings into avenues other than traditional bank deposits, as they seek a positive rate of real return on their savings. These other channels, such as investing in gold, land or stock markets, tend to add to aggregate demand and put further inflationary pressures on the economy. This can hamper medium to long run growth as the much-needed funding for infrastructure projects becomes difficult to come by due to this inefficient channeling of resources into speculative assets. For instance, the growth in bank credit to the infrastructure sector has declined steadily from over 40% in August 2010 to just over 20% in July 2011.

The recent interest rate hikes by RBI to curtail demand side inflationary pressures seem to be misdirected and are proving to be ineffective in putting the brakes on inflation. These actions of RBI, in the absence of effective communication with the public, have resulted in rising borrowing costs and persistent inflationary expectations. As a result, there has been a slowdown of credit flow to the infrastructure industry and a slowdown in capital and intermediate goods? production. This has further fueled inflationary pressures by compounding supply side shortages. Therefore, RBI actions seem to be causing cost-push inflation, rather than curbing demand side inflationary pressures as it argues.

One could, however, justify the recent interest rate hikes and also make a case for further hikes if only the economy?s watchdog makes, at least, an implicit commitment to target lower inflationary expectations in the medium to long run. This would require a major change in RBI?s communication policy with the public. The central bank would have to signal that it is dedicated to a low and stable inflation environment in the economy. That would imply surprising the market with higher than expected rate hikes and build its credibility as an inflation hawk. RBI should follow through on its action, even if the economy faces short-term pain and slowdown on account of rising unemployment or falling output. Over time, these actions would bear fruit as inflationary expectations subside and the economy can move towards a steady growth path with stable prices.

By all means, the current position of RBI to control inflation by curbing demand side inflationary pressures seems to be misguided. Under the current course of action, inflation is unlikely to subside any time soon. On the contrary, these actions will result in misdirected credit flows away from private investment in the priority and infrastructure sector, thereby further causing supply side shortages in the medium to long run. The sooner the central bank realises this and changes its course of action, the sooner we can expect inflation expectations to come under control. If targeting implicit inflationary expectations seems too much for the central bank, then the second-best course of action would be to take a hands-off approach and not cause an inefficient allocation of resources among the various sectors of the economy. We can only wait and watch if RBI learns from its mistakes!

The author is a Consultant at NIPFP and Senior Advisor and Economist at SNG & Partners. He has a PhD in Economics from Johns Hopkins University and has previously taught as an Assistant Professor at Gettysburg College. agupta28@gmail.com