Every time around monetary policy time, analysts discuss ‘inflation expectations’ of households and how that has or will influence the MPC’s stance or actions on interest rates. The RBI itself used to, and the MPC now comments on the trends in household inflation expectations as a justification for its interest rate decision. For example, one of the justifications for an increase in the repo rate in the monetary policy statement of 1
st August 2018 was this: “…households’ inflation expectations, as measured by the Reserve Bank’s survey, have risen significantly in the last two rounds, which could influence actual inflation outcomes in the months to come.”
And one of the justifications for reducing the repo rate earlier this month was as follows:
“…the Reserve Bank’s surveys show that inflation expectations of households as well as input and output price expectations of producers have moderated significantly.”
The implicit presumption amongst analysts and the explicit presumption in the MPC is that the inflationary expectations are forward-looking. That is, it is a guide to what path the inflation might take in the future. And hence, it is something that should influence monetary policy. This world view to a large extent stems from what central bankers in developed markets do where monitoring inflationary expectations is a long-established practice. There is however a big problem in using that analysis, at least, in the case of India. Data suggests that household inflationary expectations adapt to changes in inflation rather than predict the future trajectory of inflation.
There are several data points in the RBI’s household inflationary expectations survey, but the two most relevant and important are: First - household’s current assessment of inflation which is what households think inflation is currently; Second - household’s expectation of inflation in the future. The survey reports two data points for this – 3 months and 12 months. We use 12-month expectation in this analysis because that time horizon is more relevant.With this background, there are three key takeaways from this survey, which are quite intuitive, but implies that data from this survey ought not to be used as a forward-looking indicator but it is still a backwards-looking ‘reinforcing’ tool:
The first point is that there is little relationship between the reported inflation (CPI) and what households report inflation to be as per their assessment. In the latest survey in December for example, households assessed current inflation to be 7.1 percent whereas the actual inflation in the December quarter was 450 basis points lower at 2.6 percent. That’s a seemingly massive disconnect. However, this isn’t surprising. The CPI inflation that the CSO reports is, at least for households, an abstract number – a number they don’t see or experience. The same would be true of other economic variables as well such as GDP growth or IIP growth or exports. So, the fact that inflation, as assessed by households, does not match with inflation as reported by the CSO, is not a criticism or drawback of the survey – it is only to be expected. The second point is that household inflationary expectations closely align with their current assessment of inflation. This is as against a belief implicit in the way analysts and the MPC interprets this survey that inflationary expectations are independent of current inflation. Effectively, if households believe that inflation has increased in recent weeks or months, they expect inflation to increase in the future also (their inflationary expectations go up) and vice-versa. There is over 80 percent correlation between changes in current inflation and future inflation expectations of households. The third point and this is linked to the two points above, is that while there is no correspondence between what households assess current inflation to be and the actual reported inflation, the two do move broadly in sync, with a lag. The inflation ‘perceived’ by households, catches up, not in level but in trend, with the changes in reported inflation with a lag (around 2-3 quarters down the line). And since as per point two, household inflationary expectations move in sync with their current inflation, it follows that household inflationary expectations adapt to changes in actual inflation, with a lag. (Inflationary expectations explains the trajectory of inflation rather than predict its future trajectory)
Source: RBI, CSO
Bottom line then is that the household inflationary expectations only tell us what households think has happened to inflation and what households think has happened to inflation mirrors the actual movement in reported CPI data, with a lag of around 2 quarters. So, the inflationary expectations are, mostly, backwards-looking. This is not surprising. Household expectations generally are known to be adaptive which in simple terms is simply an extrapolation. Households extrapolate recent behaviour in the absence of any other base on which to form future expectations. Given this and given that the actual reported inflation has continued to fall in the last couple of quarters, a further fall in inflationary expectations is only to be expected. And also that this is not a sign of what might happen to the actual reported inflation in the months ahead.
That said, the fact that household expectations adapt rather than predict is still useful. This is especially the case now that the RBI is focussed primarily on inflation. It is one thing for the RBI to target an inflation rate based on a relatively abstract concept of the Consumer Price Index. But if households do not perceive that inflation has changed in response to RBI targeting the CPI, then the whole exercise of inflation targeting becomes pointless. The fact that households perceive that inflation has changed, albeit after a lag of a couple of quarters, suggests that firstly, the CPI data is not disconnected from the real economy and secondly that the RBI’s actions at targeting the CPI will result in households actually perceiving the change in inflation. So, RBI’s actions have a tangible impact on households.
Ashutosh Datar is a Mumbai-based independent economist.