Ashima Goyal

Anchoring inflationary expectations

Ashima Goyal | Updated on March 12, 2018

The food price-rural wages chain is a major driver of inflation expectations.

The markets’ pricing in of inflation and the expected policy stance has now started to affect monetary policy transmission.

Supply shocks, not excess demand, have powered inflation in India in recent times, so the Reserve Bank of India (RBI), even while reducing demand, has aimed it more at anchoring inflationary expectations.

But exactly how this works in the Indian context is not clear. A widely shared perspective, though, is that the RBI reducing its policy rates even marginally would amount to giving up the fight against inflation.

But then, growth is also included among the RBI’s objectives. Therefore, giving some weight to growth shouldn’t really imply it is giving up on inflation.

If its policy rates are supposed to adjust to both the deviation of inflation from its target and of output from its potential, these gaps are today very different compared with their levels last summer.

In the summer of 2011, the repo rate was 8 per cent when GDP growth was 7.6 per cent, with wholesale price index (WPI) inflation at 10 per cent and, within that, ‘core’ non-food manufacturing WPI at 8 per cent. Industry, too, was slowing even as the RBI’s tightening cycle was approaching its peak, with the repo rate being raised to 8.5 per cent in October.

Today, when GDP growth rate is at 5.3 per cent, WPI inflation at 7.5 per cent, and manufacturing WPI inflation at 6 per cent, the repo rate is still the same at 8 per cent. We are now at the start of a softening cycle. It has been on pause mode, except for a 50 basis point cut effected in April — a month when manufacturing inflation fell to 5 per cent after having touched a peak of 8 per cent in December 2011.


But despite an output gap, the markets had not priced in a cut in the repo rate before the end-October monetary policy review; nor did analysts expect any such cut. The pass-through from a rise in administered prices and rupee depreciation had marginally raised the headline WPI inflation. So, it was difficult to expect policy rates being cut when inflation was rising.

The RBI worries about unhinging inflation expectations. But what the markets believe also limits what it can do.

The irony here is that the RBI’s forward guidance also affects what the markets expect. So does its guidance anchor expectations or restrict its own action?

Throughout this period since last year, inflation was higher and growth was lower than the RBI’s guidance. In the summer of 2011, the guidance for GDP growth for 2011-12 was 8 per cent and that for headline WPI inflation in March 2012 at 7 per cent.

Actual growth for the fiscal turned out to be 6.5 per cent, while inflation stayed at around 10 per cent.

The RBI’s guidance is neither the potential output nor a medium-term inflation target. It is only the most likely point of an expected range. To the extent it is credible, such guidance should help anchor inflationary expectations in that range.

But high macroeconomic volatility, including in the currency and in oil prices, clouds the entire picture. In the event the guidance has to deviate from medium-term values, the level of nominal interest rates may not be aligned to the inflation rate. Secondly, deviations from the mean target would also be high.

It is ironic, then, that guidance acquires the greatest salience in conditions of more uncertainty, when perforce it is the least reliable.

Despite volatility, establishing credibility requires a response to persistent deviations.

But last year, the inflation and growth deviations required opposite responses. As inflation levels fell but the RBI’s policy rates were not reduced, real interest rates rose even as falling growth required the opposite.

There was room for marginal reduction in policy rates, conditional on new developments, without really unhinging inflation expectations.

A gradual loosening cycle can also be effective, since firms’ factor in lower interest rates over the life of an investment, even though rates may not yet have fallen fully.


A judgment is required on which of the multiple shocks may have a persistent effect on inflation — and, therefore, should be responded to immediately — and which of those can be allowed to pass. Public perception has to be trained to appreciate that all deviations from guidance do not require an immediate response.

Communication, therefore, has to be more nuanced even as it aims for simplicity. It must understand and use psychological effects. For example, listing the risks to a particular outlook tends to be understood only as a downside — much like the statutory warnings on allopathic drugs focus attention on side-affects. So upsides must also be consciously listed.

The markets’ pricing in of inflation and the expected policy stance has now started to affect monetary policy transmission. But the major impact on inflation expectations in India continues to be through the food price-rural wages chain that affects a much larger part of the economy.

The RBI’s own research shows food inflation to have a large impact on households’ inflation expectation, and their tendency to over- or under-predict inflation levels.

If inflation persistence is due to multiple supply shocks that kept food prices high, it can also fade rapidly with a drop in salient prices.

There are many upsides now pointing to a reduction in salient food inflation — the monsoon revival, softening of global commodity prices, plateauing wage increases, and a relatively stabilised rupee. Along with it, some government action and a large output gap also moderates general inflation.

If both GDP growth and inflation for 2012-13 end up to be less than the respective October 2012 mean guidance of 5.8 per cent and 7.5 per cent (headline WPI inflation in March 2013), the psychological moment to restart investment would have passed.

(The author is Professor of Economics. IGIDR, Mumbai. >

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

Published on December 13, 2012
This article is closed for comments.
Please Email the Editor
This article is closed for comments.
Please Email the Editor