The expectations, thus, may cause a “wage-price” spiral. This was famously seen in the inflation episode of the 1970s named ‘The Great Inflation’. The Federal Reserve’s unpredictable actions led the US into a self-perpetuating loop of higher inflation expectations and higher inflation. It took an unflinching resolve of the new Federal Reserve Chairman, Paul Volcker, to lower these expectations. This brought inflation down from a high of 18 per cent in 1980 to 3 per cent in 1982. Since then, central banks have understood the value of credibility and communication in anchoring expectations.

In the past year, however, we have seen a slow-moving Federal Reserve downplaying persistent inflation. Fed Chair Powell has admitted the delay in action and said: “In hindsight, it would have been better to raise rates earlier.” But the delay has led to hardening of inflation expectations at a higher level.

Even after the Fed started course correction in March, its credibility has not been restored. The path for quantitative tightening was also laid out. But the communication has not been hawkish enough to tame rising expectations, although that is expected to change, given the FOMC Chairman Jerome Powell’s recent testimony before the Senate Banking Committee.

Market participants are perhaps still not sure that the Fed has the resolve to do ‘whatever it takes’ to bring inflation down to 2 per cent.

RBI does well

While the Fed was caught napping at the wheel, the RBI has been awake to the dangers of the situation. When it comes to inflation, India was dealt a poor hand. India has significant imported inflation due to reliance on oil, gas, and commodity imports. This is worsened by a depreciating currency. Indian policymakers have very little sway with both these factors. But the RBI has dealt swift blows to inflation. The off-cycle rate increase of 40 basis points in May followed by another 50 basis points in June has made sure that the RBI remains ahead of the curve. The fiscal policy has also tried to support the monetary policy. The reduction of excise duties on fuel and import tariff on edible oils would lower inflation expectations of households.

The RBI has done well to start early but there is still much to be desired in the communication department. The challenge is to take hard steps without sending the markets into a tailspin. The urgency in raising rates should not lead the market to overestimate the quantum of future hikes. In such uncertain times, market participants want more quantitative guidance and make public the data relied upon by policymakers. This will ensure that inflation expectations remain anchored and financial conditions remain orderly.

Monetary tightening will impact demand and the nascent recovery. In this era of increased financial volatility and global uncertainty, transparency is critical. Central banks need to take all economic actors into confidence. Frequent communication with changing forecasts entails the risk of loss of credibility. While the opposite may lead to people forming expectations based on unreliable data. We will achieve a soft landing only if central banks walk a tight rope.

Divya Mittal is an IAS officer and Gagandeep Singh is an ex-Indian Trade Service officer