The $2 Trillion Survey
Three cheers! The RBI Governor has moved from being 'Reluctant Raghu' to 'Rate-cut Raghu!'
January 15, 2015The chairman of the $20 billion Mahindra Group, Anand Mahindra, was exuberant in his praise for the then Reserve Bank of India (RBI) Governor Raghuram Rajan's first ever interest rate cut on January 14, 2015. It seemed as though after persistent prayers from the ‘captains' of industry and the government for more than 18 months and nine monetary policy meetings, Raghuram Rajan had finally relented to grant them their wish. Except, Rajan made it clear that it wasn't the industry's entreaties that made him change his stance. It was the expectations of inflation by the average Indian homemaker.
“Households' inflation expectations have adapted, and both near-term and longer-term inflation expectations have eased to single digits for the first time…These developments have provided headroom for a shift in the monetary policy stance.”This is how Rajan justified his decision in January 2015 to reduce interest rates for the first time in his tenure by 25 basis points (0.25 percent), from 8 percent to 7.75 percent. Rajan partly justified every one of his four subsequent rate cut decisions with the same rationale – decreasing inflation expectations of households. From the time he took charge as RBI governor in September 2013 to September 2014, 70 percent of Indian households, on average, expected prices of goods and services to rise more than 10 percent over the next one year, that is, double-digit inflation. Rajan did not cut rates in this period. Between December 2014 to June 2016, the mood of Indian households changed. Only 45 percent of households expected double-digit inflation and the remaining 55 percent expected single-digit inflation. Rajan cut rates five times during this period. There was a clear observable pattern to his monetary policy decisions.
But during the recent October 2016 monetary policy, inflation expectations had once again risen dramatically. Evidently, this was inconsequential to the newly-constituted monetary policy committee (MPC) chaired by the new governor Urjit Patel. It chose to cut rates by 25 basis points despite the sharp increase in inflation expectations. So the very indicator that Rajan based each one of his rate cuts on, did not seem to have hindered the MPC's decision to cut rates in October 2016.
What is this idea of inflation expectations that seemed to have mattered so much to Rajan but did not deter the new regime? This is not to quibble over the merits of the recent monetary policy decision. This is to unravel some of the mystery behind this seemingly important indicator of inflation expectations.
Why Inflation Expectations Matter
Eighty years after the founding of the RBI, it now has a clearly legislated mandate for the first time – to keep consumer price index (CPI) inflation between 2-6 percent until 2021. The central bank's mandate is not to worry about the cost of credit to businesses or the creation of jobs in the economy, as is often misconstrued. It is in this context that the Indian households' inflation expectations matter a lot more now than it did in the past. The average Indian's expectations of future prices will influence her current purchase decisions. ‘Will mobile phone prices fall so I can buy it later? If dal prices go up next month, I need to stock up today' are the types of questions that influence our purchase behaviour. These decisions, in turn, impact actual prices based on the demand for goods and services and hence, the CPI inflation number. If households trust the RBI's ability to rein in inflation, they will then vary their inflation expectations accordingly. Consequently, their purchase decisions will also change.
If the RBI's mandate now is to keep CPI inflation in a specified range, it is important for it to earn the confidence of households and anchor their inflation expectations accordingly. Inflation expectations of households thus plays a critical role in the new inflation targeting mandate of the RBI.How then does the RBI measure such inflation expectations of the ‘aam aadmi'?
The RBI surveys more than 5,000 households every quarter across 18 cities and towns. It ensures that the survey covers a wide cross-section of society – homemakers, retired pensioners, white collar workers, financial services professionals, small entrepreneurs and daily wage labourers. The survey questionnaire covers a range of questions related to expectations of both levels and trends of future prices over a three-month period (short term) and a one-year period (long term). This constitutes the RBI's quarterly inflation expectations survey of households. Similarly, the Central Statistics Office collects monthly price data of a basket of goods and services from 1,114 different markets across 310 towns and 1,181 villages to calculate CPI inflation. This interplay between CPI inflation and households' inflation expectations lays the foundation for India's interest rate environment.
Analysis of RBI's inflation expectations surveys over the last 28 quarters in seven years show that Indian households have a perennial fear of double-digit inflation. Consistently, a large majority of the households expect prices to rise over 10 percent in the next one year. In 21 of the 28 quarters over the last seven years, a greater majority of households expected double-digit inflation. Only between December 2014 to August 2016, a majority of households expected single-digit inflation.
If the inflation expectations survey is any true indicator of households' confidence, then it is evident from the chart that Indian households felt most confident about the RBI's ability to rein in inflation during Rajan's tenure. In the most recent September 2016 survey, there has been a sudden increase in the percentage of households expecting double-digit inflation. Sixty-five percent now expect longer-term double-digit inflation, up from just 45 percent in the previous survey. It is quite obvious from this analysis that the RBI still has some way to go before it can earn the confidence of households to rein in inflation below 10 percent, let alone its 6 percent outer target. It is of course naïve to believe that people's expectations of inflation are solely determined by the RBI or its governor. So what shapes households' expectations of inflation then?
Inflationary Fears Hightened?
Economists use the term ‘adaptive' to imply that people's expectations of future inflation are shaped by their immediate experiences. For example, food prices have increased substantially in the past three months and this may have had a role in influencing households' expectations of double-digit price increases going forward. Our analysis shows that swings in CPI food inflation is three times larger than changes in households' long-term inflation expectations. Put another way, high volatility in actual food prices perhaps induces perpetual inflationary fears in people. It is for this reason that we can observe in the chart (below) that people's expectations of inflation tend to be sticky and do not change as much as CPI inflation. On average, people seem to wait for six months of observed lower CPI inflation before they adjust their expectations of long-term inflation. Notice how despite sharp upward and downward swings in CPI food inflation, longer-term inflation expectations of households are fairly steady. To be sure, our analysis also reveals that the previous three-month CPI inflation number impacts people's expectations of future inflation. But by and large, most Indian households seem to expect double-digit inflation for the most part, irrespective of dramatic shifts in CPI.
‘Focus On Broad Trend, Not Levels'
The RBI survey also asks people to guesstimate current and future inflation. This is akin to asking people to estimate the exact temperature (in Fahrenheit!) of the weather they are experiencing. It is highly likely most estimates will be inaccurate. In fact, our analysis of category-wise results of RBI's inflation survey shows that the average banker is no better at estimating inflation than the average housewife. Yet, there are reams of analysis on people's inflation expectations vis-à-vis actual CPI inflation to conclude that the survey is unreliable.
What is more important are broad trends in people's long-term inflation expectations, not actual levels of inflation.Understandably, RBI's monetary policy decisions are crucial to the growth prospects of India's $2-trillion economy. With the sole mandate of confining CPI inflation in a specified range of 2-6 percent, the RBI's objective now is unequivocally clear. To meet its objective, it is imperative that the RBI gains the trust and confidence of Indian households to believe that inflation can truly be contained within that range. Globally, inflation expectations play an important role in a central bank's ability to abide by its inflation target range. India will be no different. The recent monetary policy decision of the RBI may seem anachronous with people's expectations of inflation. Perhaps the monetary policy committee believes the recent surge in expectations is more an outlier. It is likely that the committee will watch this indicator much more closely now than ever before. Industry chambers wailing about their cost of credit or finance ministers threatening to ‘walk alone' to achieve growth notwithstanding, it is ultimately what the ‘aam aurat' believes about future prices that will likely determine RBI's monetary policy decisions. So, the next time a RBI-appointed surveyor comes to ask questions about inflation, know that your response is worth $2 trillion and answer with care!
Praveen Chakravarty is a Senior Fellow at IDFC Institute, a Mumbai based think/do tank. His work focuses on financial sector legislation & political economy. Noise to Signal will bring you insights from that.
The author is extremely grateful to Saurabh Roy, Research Associate at Pahle India for research assistance and to V Anantha Nageswaran for feedback.
The views expressed here are those of the author's and do not necessarily represent the views of BloombergQuint or its editorial team.
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