RBI may need revised strategy to lower inflation expectations

Consumer behavior partly depends on what people believe product prices will be in the future. They may buy more today if they expect prices to rise sharply, for example, pushing current inflation even higher. Families can also shift their savings preferences away from low-risk assets such as bank deposits. Workers may demand higher wages, potentially leading to a wage-price spiral.

Thus, the central bank’s job of managing inflation becomes difficult if inflation expectations are not stable or stable around its inflation target. In such cases, a short period of high inflation can result in households marking their perception of future inflation.

This makes it more challenging for the central bank to meet its inflation mandate. The increase in interest rates needed to bring inflation down to its target level would then be higher, which could further dampen economic growth.

Thus, domestic inflation expectations are an important piece of information for central banks, especially in periods of high inflation.

For example, retail inflation in the US was 8.2% in September. Average one-year forward household inflation expected in September was 5.4%. Inflation expected three years ahead was less than 2.9%, nearly 1% above the US inflation target. In fact, the American people currently, overall, believe that the current period of high US inflation is unlikely to last very long.

In India, the Reserve Bank of India (RBI) keeps retail inflation at 6.7% for the 12 months till March 2023. The upper limit for its inflation target is 6%. RBI expects retail inflation to fall to 5% by April-June 2023. Professional forecasters also expect a decline in India’s retail inflation next year. However, urban families do not agree with this.

Indian households expect household retail inflation to continue rising, according to the RBI’s latest bi-monthly inflation expectations survey of households. The average household inflation expectation for September 2023 is now 11%.

Respondents in Ranchi, Jharkhand expect retail inflation to be 8.1% a year ahead, the lowest among the 19 cities surveyed. Bengaluru, India’s IT hub and capital of Karnataka, has the highest inflation expectations of 13.5 per cent.

India releases retail inflation for rural and urban areas. We compared inflation expectations of urban households over time to real consumer inflation in urban areas, beginning in 2016, when the RBI moved to the current inflation-targeted framework.

First, since 2016 domestic inflation expectations have always been higher than actual inflation. Second, they have never fallen below the upper limit of the RBI’s inflation target of 6%. Such a pattern of domestic inflation expectations would be a matter of concern. Third, domestic inflation expectations are closely aligned with their perception of current inflation. Fourth, households do not update their beliefs as much when new data is available. For example, in July 2021, the expected average household inflation for one year to come was 11.5%. When the RBI conducted the survey a year later in July 2022, the average expectation for the same month was still 9.3%. This is despite retail inflation being very low between 4.6% and 7.3% during the last 12 months.

Despite the difference in the perceptions of domestic inflation and real inflation, the trend of real inflation is in line with the perception of domestic inflation over the same period.

To improve the usefulness of the survey, it would be worthwhile to understand the sources of recency bias in household reporting of inflation perceptions. Families may be unable to recall prices from a year ago and then mentally calculate how much prices have increased during the year they report inflation expectations for the current month.

In addition, household consumption baskets are different. As RBI notes, their expectations may reflect the price perceptions of their consumption basket rather than the overall consumer price index. But this is not an issue specific to India.

Whether and how the differences in household inflation expectations by age, region and occupation for real inflation also deserves closer scrutiny. Younger survey respondents (under 25) tended to have the lowest inflation expectations, while older respondents (over 60) had the highest. Daily workers report higher inflation expectations, probably influenced by the prices of food products.

Public awareness of economic conditions, inflation measurement and data release as well as a better understanding of RBI’s policy formulation and track record on inflation will help households to better assess their assumptions about future price changes. And the pattern of domestic inflation expectations so far calls for a reconsideration of the communication strategy of the general public as well as the RBI.

Vidya Mahambare and Praveen Kumar are Professors of Economics and Director (Research) respectively, and are graduates of the Great Lakes Institute of Management, Chennai.