Deepak Mohanty: The importance of inflation expectations
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
S P Jain Institute of Management & Research, Mumbai, 9 November 2012.
* * *
The assistance by Dr Praggya Das in preparation of this paper is acknowledged.
''Each possesses within himself two antagonistic and foolish counsellors, whom
we call by the names of pleasure and pain...besides these two, each man
possesses opinions about the future, which go by the general name of
'expectations'; and of these, that which precedes pain bears the special name of
'fear', and that which precedes pleasure the special name of 'confidence'."
Plato, 360 BC
I thank Dr. Sesha Iyer and Dr. Pattnaik for the invitation to address this young audience. In
monetary analysis and policy, inflation expectations play a pivotal role. Recently, in many
advanced economies, central banks have substantially expanded their balance sheets, which
is apparently inflationary. However, central banks in these countries allay the inflation
concerns by indicating that, despite substantial monetary easing, medium-term inflation
expectations remain well anchored. One inference, therefore, is that inflation in future is
unlikely to go up if inflation expectations do not go up. In India, we have the opposite
problem: elevated current and expected inflation constrains the Reserve Bank in
substantially easing monetary policy. This suggests that central banks, assign a significant
weight to inflation expectations in their monetary policy assessment.
How does one define "expectations" which is a behavioural and psychological concept and
apply it to economics and practical policy making? This is the theme of my talk today. I will
sequence my presentation as follows: first, I briefly review the theory and practice of defining
inflation expectations; second, discuss the measures of inflation expectations; third, analyse
the measures of inflation expectations in India; and finally, conclude with some thoughts on
enhancing our understanding of the inflation process and expectations.
Theory and practice
Plato defined "expectations" as "the beliefs about the future" more than 2000 years ago
which remains valid even today.1 Such beliefs about the future do affect the current
behaviour of economic agents. Therefore, inflation expectations can be broadly defined as
economic agents' belief or views or perceptions about inflation in the future. As humans, our
minds cannot escape thinking about the future. In a market economy, almost every economic
entity is affected by inflation in some way or other. Hence, it is reasonable to surmise that
people form their expectations about inflation.
The relevant literature identifies two ways of forming inflation expectations. The first is a
variant of adaptive behaviour wherein expectations are formed by extrapolating the past and
current experience into the future. Apart from the past experience, people do factor in new
generally available information. For example, in our case if the monsoon rains are deficient
people may expect higher food inflation and, hence, higher overall inflation. At the same
time, economic agents learn from their past errors in projecting inflation and take that into
account in forming their expectations. However, people may not change their expectations
continuously, but may stagger their revisions periodically. The key feature of these variants
of inflation expectations is that it is largely backward-looking.
The second way of forming inflation expectations in a forward-looking manner is rational
expectations. If the economic agents are forming their expectations after processing all
available information and also factoring in the reaction function of the monetary authority, it
could be considered as rational. In practice, economists derive value of expectations from
complex rational expectations models.
Empirical evidence, however, suggests that expectations are subject to significant errors,
both in its adaptive form and the rational expectations form. In a complex and uncertain world
nobody possesses perfect foresight. Even our economy, in which we form expectations,
operates with several imperfections. It is not possible to devise an economic model that
captures all the relevant variables and at the same time gives accurate predictions about the
future. It may thus be reasonable to assume that expectations formation is both a process of
adaptive learning and bounded rationality.
In terms of practice, a steady and low inflation combined with well-anchored inflation
expectations helps the monetary authority in achieving the other objectives of monetary
policy - such as economic growth and financial stability. The state of inflation expectations
greatly influences actual inflation and, thus, the central bank's ability to achieve price
stability. In a paper on inflation expectations, the current US Fed Chairman Ben S. Bernanke
explained the term "anchored" to mean relatively insensitive to incoming data.2 That is, if the
public experiences a spell of inflation higher than their long-run expectation, and their
longrun expectation of inflation changes little as a result, then inflation expectations can be
considered as well-anchored. If, on the other hand, the public reacts to a short period of
higher-than-expected inflation by marking up its long-run expectation considerably, then
expectations are poorly-anchored.
Price rises reduce the real purchasing power of individuals. Thus, if inflation is expected to
be persistently high, workers bargain for higher nominal wages to protect their real income.
This creates a pressure on firms' costs and they may in turn increase prices to maintain their
profits. Independently, the producers' own inflation expectations also affect inflation directly
by influencing their pricing behaviour. If companies expect general inflation to be higher in
the future, they may believe that they can increase their prices without suffering a drop in
demand for their output3.
In economic models with rational expectations, the inflation expectations, and hence inflation
itself, is an equilibrium outcome, strongly influenced by the public's beliefs about the policy
rule followed by the central bank. Following this insight from the rational expectations tenet,
central banks increasingly communicate their policy reaction function in terms of possible
paths for inflation expectations and by establishing inflation targets, attempting to anchor the
public's long-run inflation expectations. Since uncertainty about future inflation affects
households' purchase decision, price stability is described as an environment where
economic agents need not take into account uncertainty about future inflation in their
decision-making4.
Empirical work from advanced countries suggests that, "successful maintenance of price
stability requires keeping long-run inflation expectations at the desired level, as economic
shocks and policy mistakes come and go".5 Underscoring the importance of inflation
expectations, the Reserve Bank's Second Quarter Review of Monetary Policy 2012-13
released on 30th October 2012 noted: "A central premise of monetary policy is that low and
stable inflation and well-anchored inflation expectations contribute to a conducive investment
climate and consumer confidence, which is key to sustained growth on a higher trajectory in
the medium-term."
Measurement of expectations
While it is challenging to conceptualise inflation expectations, it is even more difficult to
measure it as it cannot be observed in real time. In order to achieve their mandate for low
and stable inflation, central banks use several methods to measure the prevailing level of
inflation expectations. For this, they seek to gain knowledge about the public's expectations
about inflation in addition to the financial market based measures. The measures used by
central banks can thus be broadly classified as market-based measures and survey-based
measures. Let me now turn to some of the measurement issues.
First, inflation-indexed bond is a market based measure of inflation expectations. It provides
protection against inflation. While a conventional bond pays its coupon on a fixed principal
amount, the inflation linked bonds provide coupon on inflation-adjusted principal amount. In
the recent years, sovereign inflation-indexed bonds have become available in a number of
countries and have provided a new instrument for use in retirement saving. The differential
yields between ordinary and inflation-indexed government bonds of similar maturity provide
an indication of inflation expectations.
Second, inflation expectations can also be derived from the yield curve of ordinary bonds of
different maturities. The expectations theory implies that the shape of the yield curve
depends on the expected pattern of short-term interest rates. The long-term interest rates
exceed current short-term rates if short-term rates are expected to rise. The yield curve thus
slopes upward. In contrast, long-term interest rates are less than current short-term rates if
short-term interest rates are expected to fall. In this case, the yield curve slopes downward.
The yield curves can thus be used to gauge inflation expectations.
Third, the survey-based approach is the other method of measuring inflation expectations.
Surveys can gauge people's expectations for inflation by simply asking them what they
expect. The survey-based methods of measuring inflation expectations are important to
policy makers and researchers because they provide data on an otherwise unobservable
variable. The surveys cover different target groups ─ usually they pertain to households or
professional forecasters. Most of these surveys present both short-term and long-term
forecasts on inflation.
Fourth, many of the households' savings and expenditure decisions such as purchasing
perishable and durable goods can be affected by expectations and uncertainty about future
inflation. Many countries, therefore, conduct consumer surveys to gauge consumer
confidence including inflation expectations. In such surveys different sampling techniques
such as pure panels and repeat panels are used.
Fifth, the Survey of Professional Forecasters (SPF) is another important source to gauge the
inflation expectations from analysts. The survey is usually used for forecasting a large variety
of macroeconomic variables in addition to inflation, viz., gross domestic product (GDP),
interest rates and the unemployment rate. As professional forecasters process large volume
of information and rely on econometric models, their forecast of inflation expectations can be
considered more rational than that of pure households.
Measures of expectations in India
I now turn to issues pertaining to measurement of inflation expectations in India. In the recent
years, the Reserve Bank has been assessing the state of inflation expectations in the Indian
economy through several means. It conducts a series of surveys aimed at different economic
agents as well as model based inflation forecasts (Table 1). These surveys have evolved
over time with periodic refinements. Let me give you some perspective on these surveys.
Table 1
Survey-based Inflation Expectations
First, the Reserve Bank has been conducting a survey of inflation expectations of
households since September 2005 to get a measure of the public pulse on inflation. The
initial rounds of the survey were only qualitative in nature and from the 3rd round, questions
about expected rate of inflation over the next three months and next one year were added.
From the 9th round in September 2007, a question on the respondents' perception of the
prevailing inflation rate was also added. A question on awareness of the public on the RBI's
role to control inflation was added in the 21st round in September 2010.
Second, the survey presents a measure of households' present perception of inflation as well
as their expectations about the near future. The inflation expectations survey of households
is conducted in twelve cities, three each from the north, south, east and west zones covering
the major metros from each zone and eight other cities. The 4,000 respondents are chosen
within a city in such a manner that a good geographical and occupational coverage is
achieved. The price expectations are sought in the survey for general prices and for five
groups: food products, non-food products, consumer durables, housing and services.
Third, the Reserve Bank's consumer confidence survey gives an assessment of the consumer
sentiments on prices, as it is an important variable influencing the overall consumer
confidence. The overall consumer confidence is assessed on the basis of respondents
perceptions of the general economic conditions and their own financial situation. The consumer
confidence surveys provide a qualitative measure of consumers' price expectation.
Fourth, the Reserve Bank has been conducting a survey of professional forecasters since
2007. The survey covers forecasters that have an established research set-up and bring out
periodic updates on economic developments. These organizations include investment banks,
commercial banks, stock exchanges, international brokerage houses, select educational &
research institutions, credit rating agencies, securities firms and asset management
companies. The schedule covers annual as well as quarterly forecasts of major
macroeconomic variables such as, real gross domestic product (GDP), savings and capital
formation, select financial market variables, fiscal deficit, policy rates, external sector
variables, along with the two key measures of inflation - the wholesale price index (WPI) and
the consumer price index for industrial workers (CPI-IW). Importantly, the forecasters are
also asked to provide their medium-term (5-years) and long-term (10-years) forecasts of
GDP, WPI and CPI-IW.
Fifth, apart from the households and the professional forecasters' inflation expectations, the
Reserve Bank captures another measure of inflation expectations - those from the
producers. These sentiments are captured from a business outlook survey which is being
conducted on a quarterly basis since 1998. The survey presents an advance assessment on
economic and industrial environment based on the qualitative data collected from select
manufacturing companies including their assessment and expectations on the input and
output price behaviour.
Finally, the results of the above surveys are used as inputs for monetary policy formulation
and are placed on RBI website for public dissemination. Salient features of the surveys are
also included in the quarterly Macroeconomic and Monetary Developments issued as a
companion document to our quarterly policy statements.
Trends in expectations
Now I turn to evidence on inflation expectations as revealed by various surveys.
First, the inflation expectations survey of households seeks information on product-wise price
expectations. It can be seen that inflation expectations were dominated by the food price
inflation: the prices of food articles drove the sentiment of overall inflation of the households
3-month ahead. The increase in price expectations with regard to household durables was
the lowest (Chart 1).
Second, similar trend was also observed for households' 1-year ahead price expectations
(Chart 2). These results are not surprising considering that food has substantial share in the
measured relevant price indices: 24.3 per cent in WPI, 35.8 per cent in new
(base: 2010 = 100) CPI-urban and 56.6 per cent in new CPI-rural.
Third, the inflation expectations survey of households uses quota sampling to get adequate
representation of the gender, occupational categories and age groups. Empirical validation
through a bootstrap confidence interval worked out for the overall inflation expectations
showed that the width of the confidence interval was quite narrow. Also the size of the
confidence intervals increases with the time horizon, indicating that the respondents are
more coherent on their perception of the current and very near term (3-months) inflation than
their expectations of near future (1-year).
Fourth, the inflation expectations of households, however, are their own perceptions based
on their own consumption basket which may not directly correspond to any official measure
of inflation. This is reflected in significant heterogeneity across households within the survey.
However, to see how the average expectations behave compared to the official headline
measure of inflation, these expectations have been plotted against WPI inflation. While there
is a significant difference in the level of inflation between the headline WPI and the survey,
notably households' 3-month ahead inflation expectations have been, by and large, tracking
WPI turning points (ex-post) (Charts 3). This suggests that the households' inflation
expectations are adaptive with significant learning. While households do not revise their
expectations unless they see changes on the ground, they are willing to change their
expectations with the actual outcome.
Fifth, while the professional forecasters give their immediate term forecast of inflation, it is also
an important source of medium- to long-term inflation forecast. The forecast of the professional
forecasters can be considered rational as they apparently process all available information
including the central bank's likely reaction function to arrive at their medium- to long-term
inflation forecasts. As regards their short-term inflation forecast, as more information becomes
available, the forecasters revise their forecasts to incorporate the latest information and the
revised quarter ahead forecasts tend to converge to the actual numbers (Chart 4).
Sixth, professional forecasters' long-run inflation expectations have been influenced by the
trend in actual inflation. In the last quarter of 2007-08, the 5-year (10-year) WPI inflation
expectations at 5 per cent (4.5 per cent) was aligned to the Reserve Bank's comfort level.
The consumer price (CPI-IW) inflation expectation was slightly higher at 5.5 per cent (5.0 per
cent). With the persistence of near double- digit inflation in 2010 and 2011, the medium- and
long-term inflation expectations have risen. As per the latest survey conducted in the second
quarter of 2012-13, the 5-year (10-year) WPI inflation expectations were higher at 6.5 per
cent (6.0 per cent). Similar upward movement in inflation expectations with regard to CPI-IW
was also seen. At the same time, the differential between WPI and CPI-IW has also widened
underscoring the role of higher food prices in expectations formation (Table 2).
Seventh, the inflation expectations were, however, significantly less volatile than
corresponding actual rates suggesting that medium- to long-term inflation expectations
remained stable, notwithstanding their recent upward movement (Chart 5).
Eighth, the manufacturing companies' assessment of changes in selling prices for the current
quarter and expectations for the ensuing quarter obtained from the industrial outlook survey
are well correlated with the year-on-year changes in the price level of non-food manufactured
products (NFMP) component of WPI.6 Thus the survey indicators provide good lead
information about the movements in the manufacturing price inflation (Chart 6).
Way forward
As I discussed above, the Reserve Bank has developed several measures of inflation
expectations over the last seven years which are providing important inputs for monetary
policy formulation. In order to reinforce this process, I make a few suggestions.
First, the RBI's inflation expectations survey of households provides a measurement of the
sentiment of inflation expectations that is essentially urban. The survey can gradually be
extended to semi-urban and rural areas of the country to enhance its representation. But
considering the strict time schedule in which the survey needs to be conducted to feed into
the quarterly monetary policy process, it may be a difficult task to have a true national
representation. Moreover, being too ambitious in the scope and coverage of the survey could
dilute its quality. Alternatively, an inflation expectations survey of the households for the rural
area can be considered. The sample villages can be drawn from the sampling frame of the
new consumer price index-rural.
Second, governments in many countries have issued inflation-indexed bonds. These bonds
apart from providing the investors a hedge against inflation, give an estimate of inflation
expectations. In 1997, India had introduced a variant of inflation- indexed bond where the
capital was indexed to inflation. There was no subsequent issue of such bonds due to lack of
investor response. Now that we have been through a period of above-trend inflation, the
appetite for such bonds may have increased. Further, the issuance of such bonds could
signal the firm commitment for containing inflation and thereby, inflation expectations as well.
It is, therefore, important that such products be introduced in the Indian debt market to get a
pulse of the market based inflation expectations.
Third, while there is substantial research on inflation expectations for advanced countries,
there is hardly any research in the Indian context. Since the Reserve Bank puts in public
domain the results of the various inflation expectations surveys, there is available data base
for research in this area. This will not only help improving the quality of the surveys but also
will enhance understanding of the process of expectations formulation in the Indian
economy. Alongside, financial market variables such as yields and futures prices could be
analysed to extract market information about inflation expectations.
Conclusion
Let me conclude.
First, it is clear that peoples' belief about future inflation is an important factor in shaping
inflation trends. But it is not so clear how these inflation expectations are formed: are they
formed purely on the basis of past experience or in a forward-looking manner after
processing all information or a combination of both? The Reserve Bank's household
expectations surveys suggest that expectations are formed adaptively with learning; but here
there is a dominance of food inflation in shaping overall household inflation expectations.
Such behaviour of inflation expectations underscores the need for the Reserve Bank to
continue to monitor in the Indian context, an array of measures of inflation - both overall and
disaggregated components, to assess the underlying inflationary pressures.
Second, even professional forecasters, who are considered more rational, have moved up
their inflation expectations. This suggests that food inflation is acquiring a structural character
feeding into inflation expectations: rather than treating higher food prices as a temporary
shock, households are assessing this as a permanent structural factor. This has inflationary
implications in terms of higher wage-price spiral. If workers' and producers' inflation
expectations go up than the latter's demand for wage increases is more likely to be acceded
to by the former. If such wage increases are in excess of productivity increase they will be
inflationary, making the inflation process persistent and raising the costs of disinflation.
Third, in 2007-08, professional forecaster's medium- to long-term inflation expectations in
the range of 4.- 5.5 per cent was well in line with the Reserve Bank's comfort level and what
can be considered growth enhancing threshold level of inflation. Subsequently, as the actual
inflation performance has deteriorated, medium- to long-term inflation expectations have also
risen to a range of 6.0-7.3 per cent. This underscores the need that the current level of
inflation ought to be brought down to better anchor inflation expectations which is vital for
maintaining price stability in an enduring manner.
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