Former US Federal Reserve chair Ben Bernanke has repeatedly stressed on the importance of inflation-targeting approach for central banks to control inflation. In the inflation-targeting framework, he also lays stress on the importance of anchored inflation expectations. In his 2007 speech at the Monetary Economics Workshop of the NBER Summer Institute, Massachusetts, he mentioned that “the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability”.
Bernanke breaks down the inflation targeting approach into two components: (1) a particular framework for making policy choices, and (2) a strategy for communicating the context and rationale of these policy choices to the broader public. The latter also includes communicating the central bank’s outlook and policy choices in a credible way. Taking the ‘right’ action alone is not the necessary and sufficient condition to achieve the desired outcome. Effective communication regarding policy and outlook is an equally helpful and important in achieving the desired objective.
RBI adopted the inflation targeting approach in June 2016. Ever since, the central bank has come out with its inflation outlook/projections in its policy announcements and has tried to steer its policy actions in the light of those projections. Inflation has remained within RBI’s target band of 4+/-2% since the target was adopted. This was, however, led by lower food and commodity prices. More importantly, households’ expectations for future inflation (three months ahead and one year ahead) have also been stable since then.
CPI inflation fell from 4.9% in FY16 to 4.5%(FY17) and 3.6%(FY18). However, inflation expectations have remained sticky. Although well-anchored since flexible inflation targeting was adopted, RBI’s latest inflation expectations survey for three-months-ahead and one-year-ahead is still running above 7%. So, what could be the reason that inflation expectations have not come down despite falling inflation?
First, RBI itself over-estimating future inflation trajectory in its monetary policy review may have led to sticky inflation expectations. RBI has been an “overcautious central bank” sometimes over-stressing on upside risks to inflation. Chief economic adviser Arvind Subramanian, in The Economic Survey 2016-17, had pointed out that in the past 14 quarters, inflation had been overestimated by more than a 100 basis points in six quarters, with an average error of 180 basis points. RBI itself admitted to this in its April 2017 MPC statement. FY18 estimations also have been no different from previous years.
Perhaps one of the reasons why RBI has been overestimating when it comes to inflation projection is due to the fact that it expected the crude oil price-fall to last much shorter than it actually did. At the same time, it expected fiscal slippage and Pay Commission hikes to create upward pressures on inflation. While core CPI has remained sticky, core WPI (non-food manufacturing WPI) has been rising. However, much of it is due to rise in base metal prices. This, again, is supply-determined and is influenced greatly by movement in global prices. While the central bank should focus on demand-side factors, these supply-side factors can’t be fully ignored.
Higher food or fuel shocks which persist over a longer period of time can feed into higher core as well as headline inflation through higher inflation expectations. This perhaps led RBI to adopt a cautious approach in the past and keep rates steady. Ashima Goyal, member, Economic Advisory Council to the PM, has been critical of RBI’s stance highlighting that “a policy-induced demand contraction affects output more than it affects inflation”. By constantly overestimating inflation in the past, the central bank itself ran the risk of higher inflation expectations and hence higher future actual inflation. In the context of ‘strategy for communicating the context and rationale of these policy choices to the broader public’, inflation expectations react very slowly to what is anticipated by the central bank, making the policy framework less effective.
Household inflation expectations have remained anchored in the sense that they haven’t been impacted much by transitory shocks. The last two fiscals have witnessed volatile oil prices and trends in food inflation reversing. However, if one is to believe that food management has undergone a structural change in India and that food inflation is likely to remain low in the future, the same is yet to manifest itself in inflation expectations. Beliefs of ‘lower, for longer’ with regards to oil prices too stand dispelled.
Second, structural changes may have hindered the effective transmission of monetary policy into inflation and inflation expectations.
Traditional rational-expectations model of inflation and inflation expectations becomes ineffective when the structure of the economy is constantly evolving in ways that are imperfectly understood by both the public and policymakers and the objectives of policymakers are not fully known by private agents. Indian economy has been subject to a quite a few structural shocks in the last two years—GST, demonetisation and bank recapitalisation, among others.
RBI now expects inflation to be 4.7-5.1% in the first half of FY19 from an earlier projection of 5.1%-5.6%. For the second half, it expects inflation to be at 4.4%, down from an earlier projection of 4.5%-4.6%. This is surprising as the central bank highlighted all upside risks to inflation in its latest MPC review. Predicting inflation is very difficult both in the long run and short run. The closer RBI’s expectation of future inflation is to actual inflation, the more effective the monetary policy transmission will be. With volatility in food and oil prices set to continue, it won’t get any easier for RBI going forward.
Mumbai-based corporate economists. Views are personal.