Transparency and clarity of communication work but RBI must do more to instil confidence in price stability
Long-term inflation expectations constitute an important variable monitored by central banks the world over in their design of monetary policy in pursuit of price stability. Keeping expectations anchored to their inflation targets over time is critical to the effectiveness of monetary policy. These expectations are considered well-anchored when they converge quickly and consistently with the central bank’s target. They are also said to be well-anchored if they are relatively less sensitive to unexpected changes in economic conditions. A deeper understanding of the anchoring of inflation expectations, therefore, aids monetary-policy formulation.
Two recent papers, one in the European context and another based on an Indian study, may shed some light on the possible direction that ought to be pursued.
Gabriele Galati, Richhild Moessner and Maarten van Rooij study long-term inflation expectations in the euro area and Netherlands through a survey of Dutch consumers. They find a de-anchoring of consumers’ long-term expectations from the European Central Bank’s (ECB) inflation target. This, however, is on account of high expected inflation rather than the reverse, and thus at variance with ECB policymakers’ concerns over a de-anchoring of long-term inflation expectations on the downside, rather than on the upside.
The study involved a random allocation of respondents into four groups, two of which were provided information on actual inflation in the eurozone and Netherlands, as also the ECB’s price-stability targets, while the other two were given no such data. The first two groups were also informed of 20-year inflationary trends. With actual inflation in the Netherlands of 2.6% and euro area of 1%, the median long-term inflation expectation of consumers with no knowledge of actual inflation was significantly higher, at 5%. Interestingly, knowledge of the actual rates and ECB targets reduced the median inflationary expectation in the case of both areas to 4%. The mean inflation expectation without knowledge were 10.56% and 11.26% for the Netherlands and eurozone, respectively, while with knowledge, this fell to 9.74% and 9.90%. Thus, transparency seems to be an important factor in anchoring inflationary expectations. Another finding: Younger respondents with higher net household incomes and higher education have “significantly lower » inflationary expectations.
G.P. Samanta and Shweta Kumari have studied the impact of transparency on the anchoring of inflation expectations in India. Transparency in India has meant a clear specification of monetary policy goals and approach towards achieving the same, the policy’s rationale in the prevailing domestic and macroeconomic context, and advance declaration of the dates of Monetary Policy Committee meetings and releases of its decisions.
Samanta and Kumari find that enhanced transparency works better in anchoring the inflation expectations of professional forecasters than households. While those of the former are anchored well within the tolerance band of the Reserve Bank of India (RBI), such anchoring, while found to exist, is relatively weak in the case of households, as their expectations are at a level beyond the upper limit of RBI’s band.
Further, such anchoring does not seem to have worked as well in the period when RBI sought to improve transparency through its setting of a disinflationary glide path and adoption of a flexible inflationary targeting monetary-policy regime. Thus, post-2016, when actual inflation declined gradually, neither professionals nor households seem to have incorporated the feedback of falling inflation into the formation of their inflation expectations.
We studied household inflation expectations data for the period May 2020 to March 2021. Such data reveals that compared to 80.9% of respondents who believed in May 2020 that prices would increase at either the same rate or a greater rate one year ahead, this proportion increased to 84.9% in March 2021. In the case of both food and non-food products, a moderate hardening of inflation expectations is seen in March 2021, compared to May 2020. Expectations of the prices of home durables and housing, however, have undergone a significant upward revision during the studied period. Compared to 53.9% of respondents last May who believed that household durable prices would increase at the same or a higher rate one year ahead, the proportion has grown to 65.9%, while in the case of housing, 72.1% foresaw such an increase in March 2021 compared to 54.2% in May 2020.
Moreover, in March 2021, the mean and median one-year ahead as well as 3-months-ahead inflation expectations are above 10%, well above RBI’s tolerance band. These expectation values are in the vicinity of those prevailing a year ago, which indicates that despite RBI’s transparency and reduction of its repo rate to a low of 4% since March 2020, monetary-policy effectiveness in anchoring inflationary expectations in India remains a question mark.
While transparency and communication are important, RBI should focus on instilling trust in monetary policy, besides gaining a better understanding of how consumers incorporate and update inflation expectations and also the role of socio-demographic characteristics in anchoring these. Otherwise, inflation-expectation surveys may be yet another case of people not putting their money where their mouths are.
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