India’s inflation has been falling, with the consumer price index (CPI) inflation touching a low of 2.3% in the month of November.
India’s inflation has been falling, with the consumer price index (CPI) inflation touching a low of 2.3% in the month of November. Surprisingly, even with the CPI inflation falling, household inflationary expectations remain high. According to a survey by the Reserve Bank of India (RBI), household inflationary expectations in the current year have remained close to 10%, even while the actual CPI inflation has averaged 4%. Household inflationary expectations are a critical parameter as these could impact actual inflation through households’ wage-price negotiations and consumption/saving behaviour. In simple words, higher household inflationary expectations can put upward pressure on actual inflation. India’s central bank has been successful in containing the CPI inflation in its target range of 2-6%, but somehow this success has been elusive when it comes to reducing household inflationary expectations.
It is not surprising that household inflationary expectations are higher than actual inflation. Consumers tend to remember price increases more than price falls. Globally also, generally, household inflationary expectations have been found to be higher than actual inflation. For instance, the US household inflationary expectations (as measured by the University of Michigan consumer survey) for one-year ahead are currently at 2.7%, higher than the US CPI inflation of 2.2%. However, what is surprising in India’s case is such a wide and persistent gap between the two.
Before we delve deeper into the mystery behind India’s high inflationary expectations, it is worth taking a quick look at how RBI arrives at household inflationary expectations. RBI surveys around 5,800 households, from 18 cities, covering different age groups and occupational backgrounds. So, the survey covers people from financial services, homemakers, self-employed, retired persons, daily-wage workers and others. Apart from inflationary expectations (three-months’ and one-year ahead), the survey also captures inflationary perception (what households think is the current inflation). This is where the interesting bit lies. The survey results show that households’ perception of inflation in the current year has been around 8% (average), much higher than the average CPI inflation. An individual’s perception of inflation has a high influence on an individual’s inflationary expectations. In simple words, this means that while the average CPI inflation in the current year has been around 4%, households’ felt that inflation during the year was around 8%, and hence they expect inflation one-year ahead to be at 10% (little higher than what they currently perceive inflation to be).
Now, why is the household inflationary perception so high? Inflationary perception should be influenced more by prices of frequently-purchased items such as food and fuel. In that sense, it is surprising that inflationary perception is still high, given the disinflationary trend in CPI food. Fuel inflation has been high in the current year (because of the sharp rise in global crude oil prices, before the recent drop), and perhaps that could be putting upward pressure on household inflationary perception. Another reason could be the increasing share of non-food items such as health, education, entertainment, personal care and other services in the consumer basket. Inflation in these items gets captured in core inflation. Core inflation has remained relatively high and sticky at around 5-6%. So, is core inflation pushing up inflationary perception? Or it could simply be the high CPI inflation of more than 10% that we had just five years ago. Maybe the high inflation witnessed in the past has resulted in household inflationary expectations getting anchored at high levels.
One may even question the sanctity of RBI’s Inflation Expectations Survey (IES). One critique of IES is that it covers mainly urban areas, whereas CPI covers rural and urban areas. However, that is not a very satisfactory explanation for such a wide divergence. Ravindra Dholakia, a member of the Monetary Policy Committee (MPC), has raised concerns regarding RBI’s IES. Interestingly, Dholakia pointed out that business inflation expectation in India as measured by a survey by IIM Ahmedabad is much lower (4.5% in August 2018).
Business inflationary expectation is also critical as it would impact actual inflation through pricing by firms, wage fixing and investment.
While businesses may be more tuned to actual inflation, another survey by RBI for gauging consumer confidence also shows households’ concerns on the inflation front. According to the survey, consumer sentiments have been lingering in the pessimistic zone and one of the big concerns of households is rising prices, apart from lack of employment opportunities and income growth.
The wide differential between inflationary expectations and actual inflation is not a recent phenomenon. The CPI inflation has come down in the last five years to an average of 4.8% (from a high of 9-10% that we have seen in the past). However, average inflationary expectations in the last five years have been around 10%.
According to yet another study on inflation expectations (by Oliver, Yuriy, Saten and Mathieu), apart from perception, household inflationary expectations are influenced by shopping experience and also media coverage. The study notes that there is limited evidence of the impact of monetary policy actions on households’ inflationary expectations, especially in developed countries where inflation has been contained at low levels. Even in the case of India, it is logical to assume that households will be having limited knowledge of inflation dynamics and monetary policy. This makes RBI’s task of lowering inflation expectations even more difficult. As far as media coverage is concerned, it’s quite likely that the coverage of inflation is relatively less when prices are falling than when prices are rising. Could that be the reason for Indian household inflationary expectations being stuck at high levels, even while actual inflation has been falling? While there are no clear answers/solutions to this puzzle—of high inflationary expectations and low actual inflation—RBI definitely needs to address this issue, to make the inflation-targeting framework of monetary policy more effective.
(The author is a corporate economist based in Mumbai)