The Monetary Policy Committee (MPC) held rates constant for the sixth consecutive time in its recently concluded meeting. The inflation input of December 2023 at 5.6 per cent though was within the comfort zone, it remains above the target of 4 per cent. The move of the RBI to hold rates was on somewhat expected lines. The decision to pause also signals that the RBI is more confident in reining in inflation. It also speaks volumes of the achievement of the RBI in anchoring inflation expectations.

The RBI had launched two crucial surveys — the Inflation Expectations Survey of Households (IESH) and the Consumer Confidence Survey (CCS). The IESH aims to capture the subjective assessment of inflation and also the expected rate of inflation for the next three months and one year, respectively. The CCS is more of an assessment of the general economic situation, price level, employment prospects, etc. These surveys not only provide a signal to the central bank but also act as a critical input in setting the rates.

The rates announced by the RBI are also a signal about the commitment to keep inflation within the comfort zone of the economy. These surveys help establish an unseen two-way dialogue between the agents and the policymaker. In many ways, it’s a circular flow of coordination between the central bank and the households where the systematic input of the households enables the central bank to arrive at the optimum policy thereby keeping inflation stable. The stability of inflation establishes the credibility of the central bank which helps shape household decisions and expectations.

Two categories

Expectations can be categorised into two main types — backward-looking and forward-looking. The former shapes its views based on current or past information and the latter forms its views from a broader array of information which is relevant to future economic conditions.

For the central bank to achieve the desired effect with its policy tools, the economy must have a higher proportion of its agents forming forward-looking expectations. Forward-looking learners also enable the smooth transmission of monetary policy.

A higher ratio of agents with backward-looking expectations may inflict a higher cost on the economy as the central bank may need to tighten more than expected to yield the desired result.

Consumer expectations about inflation are also critical because they carry the input of their spending and saving decisions. Rising inflation makes people prepone their purchasing decisions and, at the same time, demand higher wages. The higher wages then propel the prices further, resulting in a spiral. Therefore, central banks need to address the past causes and future expectations about inflation where global economic forces intersect consumer psychology. The IMF was also quick to point out the role of inflation expectations in the near term after the Covid pandemic which had resulted in inflation hitting four-decade high figures in the US, the UK and Eurozone.

The circular coordinating mechanism between the central bank and the households can work in sync if the economy has a higher ratio of forward-looking learners. To cultivate more forward-looking learners, central banks have to ensure transparency and credibility of monetary policy along with clear and effective communication which makes them accountable. The credibility of the central bank is developed over time when monetary policy has been successful in keeping inflation close to the policy target for an extended period.

It is rightly said that if the central bank is successful in anchoring inflation expectations then it has won half the battle. Central banks have a tighter rope to walk in this scenario as household inflation expectations are more responsive to price rises than price falls, implying it is more difficult to revise expectations downward than upward. Persistent high inflation also carries the risk of de-anchoring where the central bank might need to engage in steep rate hikes. Therefore, central banks need to go beyond monetary aggregates and other financial market indicators and take into cognisance of the thought process driving the participants in the real economy.

The writer is Joint Director, Government of India. Views are personal

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