Inflation seems unstoppable. But right now, most global central banks and their policy actions through unglamorous rate hikes, are largely going after only one thing -- managing the consumer psyche. Sounds like a cruel joke, as if the trauma of rising prices isn’t enough, but read on. Economists and policymakers call the process ‘anchoring inflation expectations.’ It doesn’t stop price rise as such, but pre-empts a build-up of price shocks in say rents, wages, services, or otherwise called the second-round effects.
In India, food and fuel prices constitute 55% of the CPI basket, but clearly much of the increase is due to external factors and beyond the control of either the RBI or the government. In the face of high food and fuel prices, households -- whose consumption accounts for nearly 60% of our GDP -- adjust, rather cut down, their spending. It’s a logical thing to do, but central banks don’t want this segment to needlessly fear inflation and alter spending beyond what’s necessary. So they raise rates to ‘anchor’ high inflationary expectations when temporary price shocks entail the risk of getting transmitted into actual inflation. The question is, what does temporary mean? By RBI’s own projections, inflation will stay above 6% for next three quarters, ie., at least until December.
Moreover, the latest round of RBI’s household survey (in May) found that households’ inflation expectations for three months ahead didn’t change much compared to last year, but one-year ahead expectations jumped about 1%. As Deputy Governor Michael Patra recently noted, if RBI does nothing, it’ll be seen as accommodating the inflation shock, reinforcing the public’s view that inflation may persist, broaden and rise further. So, it must show that RBI is serious by tightening more than expected, which is why we saw an unscheduled 40 bps rate hike last month. In other words, raising rates demonstrates RBI’s commitment to price stability and imparts credibility to monetary policy.
But that’s that. The ongoing rate hikes won’t lower headline inflation, which will remain elevated throughout FY23. Empirical evidence shows that inflation above 6% is unambiguously harmful for growth, so RBI will remain hawkish. But how much more tightening is in store?
There are diverging views among RBI’s Monetary Policy Committee (MPC) members. While external appiontee Ashima Goyal believes the one-year ahead real rate must not be more negative than -1%, Jayant Varma prefers a ‘modestly positive level.’ Real rate is the interest rate adjusted for inflation. In May, inflation stood at 7.04%, while repo rate is currently held at 4.9%.
So far, the MPC has raised rates by 90 bps, while inflation projections shot up by 100 bps from 5.7% to 6.7%. Which means, notwithstanding the two rate hikes, the real rate didn’t move a jot. This, as Varma noted, is akin to Lewis Carroll’s adage that we must run as fast as we can, just to stay in place, and to go anywhere we must run even faster. It means, more rate hikes.
In fact, the MPC’s stated objective is also take the repo rate at least above the four quarters ahead inflation forecast. It means, given Q4, 2023 inflation is estimated at 5.8%, there’s scope to raise rates by an additional 90 bps. But how soon will this be delivered depends on how inflation moves. As Patra noted, if headline inflation moves down in the second half of the year, the objective of taking the policy rate above the level of future inflation will be achieved sooner than later. But he forewarns that such monetary tightening implies a downward revision in growth expectations to around 6% from the embedded 7% in FY24, because monetary policy works with lags.
The good news is, there are signs that inflation may be peaking, according to Patra. For one, the excise duty cuts will have kicked in, knocking off 20 bps from headline inflation in June and he believes, the second order effects will take effect by then and soften core inflation. Which is why, he hopes the next monetary policy action could be ‘more moderate’ than elsewhere in the world. Still, we may have to wait at least two years, ie., till FY24, to see inflation back in the target range of 4%.
Inflation expectations
Inflation expectations are what people expect future price rise to be. They matter because these expectations affect people’s behaviour
Policymakers use inflation expectations as a barometer and anchoring inflation expectations is one of the key steps to keep inflation within the target zone
There are three types of inflation expectations measures: market-implied -- dervied from observed prices of certain financial instruments (spot and forward rates), survey of professional forecasters’ epxectations (what economists think) and surveys of consumers’ expectations (households and businesses)
Inflation expectations affect how workers and firms set prices and wages, determine the level of real interest rates and importantly, provide an indication of the central banks’ inflation targeting credibility