The Hindu Business Line : Inflation expectation

From the RBI's Credit Policy statement, it is clear that the central bank is much exercised by inflation expectation. The RBI Governor wants — as is apparent from the Policy Statement — to ensure that adequate preparations are made to move towards a system that would throw up information containing insights about the future state of real activity and inflation. A. Vasudevan explains inflation expectation and the RBI's strategy.

AN INTERESTING aspect of the Annual Policy Statement of the Governor of the Reserve Bank of India for 2005-06 relates to the importance bestowed on the stabilisation of inflation expectation in the current world of uncertainty. The words `inflation expectation' occur at least eight times in the section dealing with the stance of monetary policy.

`Inflation expectation' in India is generally understood to mean expectations that are based on the information on the price changes in the past. This is what economists call adaptive expectations. The RBI's observations in the policy statement that "the deterioration in inflation expectations on the basis of observed acceleration in headline inflation" in 2004-05 and "such deterioration occurred under conditions of overhang of excess liquidity, strong credit growth, incomplete pass-through of oil price shock and uncertainties about its second round effects" seem to suggest that the central bank considers the past inflation trends as influencing the economic units in formulating their expectations about how prices would move in future.

If this interpretation of the RBI's stand on inflation expectations is correct, it should be dismissed as overly narrow. There is no doubt that the latest information about macroeconomic developments and international events including those on the oil price front would influence inflation expectations. Perhaps, the information about the surveys of future inflation that is periodically made available in many developed countries too would play a part in the formulation of the inflation expectations in India.

The main problem, however, is how does one explain as to how inflation expectation and nominal interest rates are linked. In the economic literature, one of the most widely used measures of inflation expectation is what is called the `break-even' inflation rate. The concept of the `break-even' inflation rate is not widely known in India and, therefore, requires explanation here.

It is well known that almost all market participants and surely the central bank of the country work out real and nominal yield curves from bond markets.

The nominal and real rates are useful in calculating the implied `break-even' inflation rate that would act as an important indicator of market inflation expectation. And inflation, according to the standard literature, is derived from the movements of consumer price indices.

Conventional wisdom suggests that where the bond markets are efficient and arbitraged by investors, then both the index-linked bond market as well as the conventional bond market would contain the same information about the difference between nominal and real interest rates, the difference being taken as the investors' expectations about the future inflation rate.

The conventional definition of the break-even inflation thus refers to the average inflation rate that would have to take place over the life of the bonds such that the non-zero indexed bond would generate the same nominal return to maturity as the conventional bond. Only then does the `break-even' happen.

The world, however, is never this perfect. Interest rates and commodity inflation have often been unpredictable because of their high variability. One, therefore, tends to view the implied inflation forward rates as a useful proxy for the investors' expectations of future inflation.

Ideally, the break-even rate of inflation would be easily derived if there are along with conventional bonds, inflation-indexed or inflation-linked financial instruments worth the name. But such instruments, that is, indexed bonds and index-linked swaps have not made much headway in the Indian financial sector.

On the other hand, indexation of bonds and swaps is a common feature in many industrialised economies. In the UK, for example, inflation-indexed bonds have a significant market.

It is not that no attempts were made to study the UK experience and develop index-linked bond market as much as the conventional bond market in India. In fact, the RBI had sponsored a study on the subject of indexation of bonds by Prof Vikas Chitre in the mid-1990s.

Prof Chitre's study was a serious one but its suggestions were not taken up immediately partly because of the absence of a well-developed market for government securities.

Perhaps the then prevailing shadow of the scam about the irregularities in the operations of the gilt-edged market also had to do with the policymakers' reluctance to enter unknown territories. Now is the time for introducing more and more of index-linked bonds and swaps since the government securities market is relatively well developed and is being made secure by technologically savvy settlement systems almost on real-time basis.

What does all this imply? First it must be clearly understood that nominal interest rates are not measures of inflation expectation. It is, therefore, important now to conduct technical work on break-even inflation rates and inflation expectation with latest financial market data, together with development of forward markets.

Besides, it would be useful to conduct surveys of market expectations about future inflation. Perhaps because surveys and research take time, the RBI's policy statement proposes a quarterly review of the stance of and the measures of monetary policy and to retain policy discretion "to consider measures in a calibrated manner in response to evolving circumstances with a view to stabilising inflationary expectations."

The quarterly reviews in a sense are an answer to those who consider periodic inflation reports to be useful guide to the varying shifts of emphasis the central bank places on the objectives of price stability and promotion of investment and export demand for accelerating growth of output with time. Such reviews would also take care of any possible cynicism that the RBI is merely mimicking the trends set by countries that follow inflation targeting as the main objective of their central banks and produce inflation reports.

The RBI's Policy Statement reiterates what was set out as the overall stance of monetary policy — "to pursue an interest rate environment that is conducive to macroeconomic and price stability and maintaining the momentum of growth" that is consistent with the multiple objectives of the Reserve Bank. This statement is a close approximation to what economists refer to as the Taylor rule — the rule that in essence focuses on the need to minimise the gap between the actual output growth and potential growth, and the gap between the actual rate of inflation and the target rate of inflation.

The RBI's communication strategy is subtle and in terms of content, akin to that of the US Federal Reserve. The subtlety lies in the fact that there is no admission that any rule is followed explicitly. But if it is followed implicitly along with observations to retain discretion to take measures as circumstances warrant, as the Fed does, one should not grudge. For, the Governor wants — it is apparent from the Policy Statement — to ensure that adequate preparations are made to move towards a system that would throw up information containing insights about the future state of real activity and inflation. It should pave the way to having a formalised monetary policy committee or open market committee, assuming that the Centre is keen on promoting good transparency practices and financial market discipline.

For analysing all the financial market information, the data generated and placed on the web sites would have to be much larger than what are currently available so that they would truly reflect the financial market developments and behaviour. The diversity and the size of statistical needs and the research content of economic analyses would have to shift even if it implies that the Reserve Bank's own discretion would be constrained by the profiles, both of the present and the future, of financial market expectations.

(The author, a former Executive Director of the Reserve Bank of India in charge of economic and statistical research, can be accessed on asurivasudevan @hotmail.com)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Enabling enclaves

Inflation expectation — What it means and implies

Everybody blamed Somebody when Nobody did what Anybody could have done

Can you tell if any sheep are lost without counting them?

Twist in the SOX tale

Monetary Policy 2005-06 — Lending priority to infrastructure

All that glitters is not gold

`Mud slinging is an occupational hazard'

Unannounced power cuts

Priority sector lending