Time to shed excessive fixation over inflationary expectation in Monetary Policy Making

The Last 3-4 years inflation control has become the dominant theme of our monetary policy making with just a lip service to growth and even lesser concern for what is needed most by the democracy – employment. Inflationary expectations have become the mascot of inflation and taming it has become a near exclusive fixation. the current approach fails to incorprate lessons from the recent advances in behavioural economics
Inflationary expectations have stayed stubborn and unrelenting at 8-10% even while CPI inflation has been has been drifting downwards to around 3-4% for several months.
There are some fundamental issues with expectations of individuals.
Firstly, do retail consumers (unlike equity investors) from whom data is gathered for consumer inflationary expectations have sufficient information and expertise to predict inflation even if they are the ones who are affected? People dislike risks and as Daniel Kahneman theorises people dislike losses twice as much as they like profits. There is hence a tendency to overestimate risks and the losses especially the non insurable ones. Even RBI itself has been consistently overestimating inflation.
Secondly, mind comprehends or estimates prices more based on purchase cycle. For example, a vegetable or fruit purchaser might think or worry about what will it be in the next two weeks. But it will be futile to ask him for an estimate of prices 26 or 48 weeks hence. RBI data gathering does not reckon the purchase cycle.
Thirdly, the nature of human mathematical comprehension itself and translation thereof into annual numbers. Even if they knew rightly that the weekly inflation of two different items are 0.2% and 0.5%, they will most likely come up with annual numbers in the region of 6-10% (instead of 11-30%). RBI’s data on various class wise inflation expectation figures reveal how the expectations are in a significantly narrower band than the experience of the preceding few weeks or months which should have had a significant influence on their expectations. Vegetables prices vary by as much as 40% between March and September (RBI’s Mint Street memo 19), yet this is never captured in the expectations reported which stays flat at 8-10% for most of the times.
How much do expectations drive actual behaviour.
This is the most crucial question that would govern the success or failure of the current approach. Unless it can be demonstrated that people’s behaviour (in direction as well as quantum) is consistent with their inflationary expectation using it will be as perilous as a trap shooter shooting before the bell and hoping that somehow the clay pigeon will show up where the shotshell goes.
How much inflationary expectations will affect consumers buying behaviour depends on several factors like the life cycle of the product itself, per transaction costs, costs of advancing or postponing buying decision and the alternative (even if short term) investment avenues and cost of funds (borrowing costs).
A 15% annual inflationary expectation in real estate might make many to advance their purchase of house sooner than later more so if the financing costs are lower and perhaps even reallocate from other items to beat the market. But the same inflation expectations for petrol and diesel prices (roughly 1.12% on monthly cycle basis) may not make a car or 2 wheeler owner to tank up on empty cans to cover his next purchase. The same rate (0.264% on weekly cumulation basis) would not make anyone to stock up on vegetables especially given the cost of preservation and possible deterioration.
The House owner will most definitely compare his cost of borrowing with his expected price increase in house prices to make his purchase decision. But for articles of daily consumption or even white goods the household consumers are unlikely to be swayed by inflations of the range one is talking of in India. This can be gauged by the discount quantum announced during festive seasons or season end sales in India – upwards of 15-20% of sale and in some items 40% or one free for every one purchased and so on. One does not hear of 1-2% off on discount sales open only for 1-2 days (a 2% discount ending in 2 days translates to a cumulative 3500% p.a.) even for ‘definite to be purchased’ articles of consumption like clothing, household supplies etc. It does not have any impact. Even the pensioners may not be influenced to stock up even when their savings may be earning just 6-8% annual interest rates.
Unless inflationary expectations translate to rational choices by consumers, the current approach will on most occasions result on excessive action. And as RBI’s data clearly proves that as far as India is concerned, inflationary expectations are not necessarily rational expectations.
Only when inflation becomes high (say 20-25% for India) and the interest rates are way lower in comparison or in a hyper inflation (like in Venezuela now), would people be driven to rush their purchases fuelling the price increase further. The current approach at inflation levels of 4-6% seems like having a foot firmly on the brake pedal as a precautionary measure while driving at 1 kmph. Actually many end products in agri and manufacturing sector are crying for a better inflation to neutralise their cost increases.
A case for differentiated approach
There is good case for junking our inflation control focus of monetary policy making. If our economists have faith in their own icon, Philips (after whom the curve linking inflation and unemployment is named), even in short run they would be forced to conceed that a low inflation is a leading likely cause of the current unemployment crisis. We can just use the last 2 months or quarters inflation to decide what to do and should it be necessary convene the review meetings at closer intervals whenever necessary.
Rather than a single objective whatever the inflation, we should move a into differentiated approach depending on levels of inflation. Upto 4-6% inflation we should focus on job creation, between 5-8% may be on growth and employment and thereafter inflation control can take primacy.
Our industrial capacity utilisation is stuck at about 75% for a long time now. The lowest hanging fruit to be harvested for employment and growth is to put the unutilised 25% to use. It would take a bold approach to identify the more viable ones amongst these and provide them with 4-6% working capital, which could make them chugging again. A growth of an additional 2% will deliver more goods and services to the consumers and tame inflation and create employment far better. But such a sensible approach would be blasphemous to our orthodox theorists.

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