The Hindu Business Line : Inflation: No great expectations

Inflation targeting framework has to work against the backdrop of inflation expectations. And, if estimating inflation expectations has been intractable in advanced countries with well-oiled institutional structures, it will well nigh be impossible in countries such as India, says K. SUBRAMANIAN.

It should have surprised many, especially monetary economists, when the Reserve Bank of India Governor, Dr Y. V. Reddy, announced on March 16 that it was important to study inflation expectations to gauge the sentiment of the common man and that the central bank would undertake a survey.

In recent years, the RBI has adopted a broad-based multiple indicator approach which captures several variables, including price levels. As its goals, it encompasses price stability, output growth, reduction of exchange rate volatility and financial stability. The area is indeed complex and, in a speech delivered in Mumbai on, the Governor explained it as "managing the impossible trinity."

What appears new is the idea of assessing "inflation expectations". The larger issues are whether it is possible to estimate inflation expectations . What are inflation expectations and how to handle them?

A school of monetary economists suggested inflation target framework (ITF) for central banks. Prof Ben Bernanke, Chief of the US Federal Reserve, was a leading advocate. In a decade, 24 countries, mostly developed, adopted it. The Washington Twins promoted it vigorously under the banner of financial reforms.

Fighting inflation

It was a simple idea thrown up by the years of Great Inflation when the need was felt for an agency — central banks — to fight inflation independently, that is, without political interference.

Inflation targeting, it was argued, would make it easier for the financial market, business and public to understand the goals and effects of monetary policy. ITF has to work against the backdrop of "inflation expectations".

Further, to have credibility, it was explained, the system should be explicit, rule-based and with commitment by the central bank to the inflation target. Though many countries adopted the ITF, the regime was not tested by inflationary shocks of the 1990s when economic conditions were benign. The infirmities and fallacies attached to the ITF came to light in later years as more researchers studied the issues.

In March 2003, Prof Lawrence Ball of Johns Hopkins University and Niamh Sheridan of the IMF, presented a seminal paper "Does inflation targeting matter?" at an National Bureau of Economic Research (NBER) Inflation Targeting Conference. Their comparison of the experience of seven OECD ITF countries with 13 non-ITF nations showed no evidence that inflation targeting improved performance. Prof Luke B. Willard of Princeton studied it in greater depth and confirmed that "at best there is only weak evidence that inflation targeting contributed to the reduction in inflation experienced in developed countries in the 1990s" ("Does Inflation Targeting Matter? A Reassessment", CEPS Working Paper No 120, February 2006).

Not a fixed phenomenon

Questions were raised about the concept of "inflation expectations" and how realistic and quantifiable it was. Some NBER studies suggested that there was substantial disagreement among both consumers and professional economists about expected future inflation. The disagreement varies deeply through time, moves with inflation, the absolute change in the value of change in inflation, and the relative price variability. Sadly, inflation is not a fixed or predetermined phenomenon.

What is deficient in much of ITF exegeses is that they treat the entire economic community as a homogenised mass with identical expectations. They do not deal with differentiated societies with income disparities.

At its crudest, ITF works on the behaviour of investors who discount bond yields with reference to their estimates of inflation. The difference between the short-term interest rate and the bond rate becomes the indicator of expectations and the anchor for the ITF. This approach has run aground in recent years and the former Fed Chief, Mr Alan Greenspan, was baffled by the inverted yield curve. He described it as `conundrums' of the bond market. In fact, the prime anchor for ITF was removed when global capital flows began to move upstream, south to north.

Leaving aside inflation expectations, there are difficulties even in estimating inflation with reference to conventional variables. Prof Stephen Cecchetti of Brandies University and two other researchers studied the role of 19 variables as potential inflation indicators (The Unreliability of Inflation Indicators, Federal Reserve Bank of New York, Current Issues in Economics and Finance, April 2000). No single indicator clearly and constructively improved autoregressive projections. They elaborated thus: "The indicators we found to be reasonably well correlated with overall price inflation either are inherently difficult to forecast independently of inflation or bear an inverse relationship to inflation that defies all logic."

In a critique of inflation targets, Samuel Brittan commented that inflation targets alone would not be a permanent regime such as the gold standard or the Bretton Wood system and said: "One sign of fraying at the edges is the arguments that have developed about how to measure inflation" ("Inflation targets lose their glamour", Financial Times, January 16,2004).

Attack on model

Belgian economist Prof Paul de Grauwe levelled a more serious attack on the inflation model ("Central banking model for neither gods nor monkeys", Financial Times, July 25, 2006). He decried the concept of rational expectations in which "agents were given God-like features allowing them to see through the complexities of the world."

He felt that the model of perfectly well-informed optimisers fails to take into account the recent findings of psychology and brain sciences. "The uncertainty that central banks face today is very different from the one found in rational agent models."

There is a great deal of unpredictability concerning the effects of interest rate policies. The economy is subject to shocks and cyclical changes and the central banker is at a loss to comprehend the developments and decide upon corrective action.

Cold comfort to Fed

On March 9, there was a meeting of the US Monetary Policy Forum attended by leading bankers and economists. It discussed a report on "Understanding the Evolving Inflation Process".

The report was the result of collaborative effort between university and market economists. Among others, the report finds that since 1985, surveys of public expectations of inflation have lost their ability to predict the direction of inflation. Now, "expectations seem more likely to follow than... Lead inflation." They add a cautious note: "Measures of US inflation expectations cannot be relied on to anticipate future movements in the US inflation... " This is cold comfort to the Fed and to the ITF protagonists. Prof Ben Bernanke himself seems to have changed course as evidenced from his exchanges with the Congress and Senators. He is confronted with the dilemma whether he should fight inflation or promote growth.

Estimating inflation

If estimating inflation expectations has been so intractable in advanced countries with well-oiled institutional structures, which transmit shocks or prices, it will well nigh be impossible in countries such as India.

It is not suggested that the RBI is not aware of the imponderables and Dr Reddy has expounded profoundly the complex relationships. It is desirable that the RBI should step up its efforts to signal trends in inflation and establish a research project drawing on national expertise. However, it should not get trapped into the ITF mode.

(The author, a former Finance Ministry official, has experience in international, financial and trade issues.)