Growth concerns have received renewed attention in both developed and emerging countries. This can be seen from the expansionary monetary policy pursued by major central banks. While the ECB and the Chinese central bank have gone for further rate easing, the BoE decided to provide monetary stimuli worth €50 billion on July 5, 2012.

The Fed last month had not only extended ‘Operation Twist’ but also kept open the option of providing additional monetary stimulus. These developments have put the RBI in a tight spot, as it has preferred to play down the growth concerns in its last policy review. Unlike the positive surprise thrown in its Annual Policy in April, the RBI opted for a status quoist approach in June.

The growth slowdown of a higher magnitude in the fourth quarter and the RBI’s earlier indication that growth would get a higher priority had given rise to expectations of a 25 bps cut in policy rates. The central bank’s objections to a mainstream demand for a rate cut were premised not only on higher headline inflation numbers, but also on higher inflationary expectations. While there is little disagreement that headline inflation numbers are beyond comfort levels, the RBI seems to have been misled by the high inflationary expectations.

Gauging Expectations

Anchoring inflationary expectations has been one of the stated objectives of the RBI in the prevalent high inflationary environment in India. It strives to moderate inflationary expectations by bringing down headline inflation. There are broadly two ways of ascertaining inflationary expectations: Direct and indirect. While the indirect method tries to gauge inflationary expectations from the yield spread, the direct method involves asking economic agents about their views on future inflation.

The RBI tries to gauge inflationary expectations through a survey of households conducted by it on a quarterly basis, something it has been doing since September 2005. The survey captures the inflation expectations of 4,000 urban households across 12 cities for two time horizons: Three months ahead and one year ahead.

The latest survey conducted during Jan-March 2012 quarter revealed that households expected inflation to be 11.7 per cent in the next three months and 12.5 per cent in the next one year. In fact, the inflation expectations of household have remained consistently above 11 per cent in all the four quarters of the calendar year 2011.

These are certainly very uncomfortable numbers and signify that inflationary expectations are quite high. At first glance, this may justify the RBI’s concern about higher inflationary expectations.

However, it is important to note that higher inflationary expectations are not a fall-out of recent developments. When the RBI began its rate tightening in March 2010 and continued with 13 hikes, both the three-months-ahead and one-year-ahead inflation expectations remained in the range of 11.4-12.4 per cent and 11.9-13.3 per cent, respectively, in all the 7 surveys between June 2010 and December 2011. In fact, both the three-months-ahead and one-year-ahead inflationary expectations increased between June 2010 and December 2011. Inflationary expectations in both time horizons have actually seen a moderation in the March 2012 survey.

Limited Utility

Why is it that despite successive rate hikes, the inflationary expectations have not dampened? There could be three reasons: Narrow coverage, urban bias of the survey and limited awareness about the RBI’s actions. Let’s consider each of them. The survey reveals that general price expectations of respondents are more aligned with food price expectations as compared to other product groups. Around 90 per cent of the respondents appear to have been persuaded by expected changes in food prices for forming their price expectations. As primary articles inflation has been in double-digits in all the months between Jan 2011 and May 2012 except during November 2011 and February 2012, it is no surprise that respondents are expecting higher inflation.

The inflation expectation survey is confined to urban pockets and ignores the vast rural population. Given that urban middle-class is more vocal about inflation, it is possible that the inflationary expectations have an upward bias. In view of the limited appeal and utility of the survey, too much should not be read into their findings.

As inflationary expectations are crucial in monetary policy formulation, it would serve the economy better if the RBI were to expand the scope of its expectation surveys to correctly ascertain the same. Till such time, it would be better if the central bank adopted the indirect method to ascertain inflationary expectations. In the upcoming policy review on July 31, the policy tilt should be to revive growth unless there is clear indication that easing would aggravate inflation.

(The author is Associate Dean, Xavier Institute of Management, Bhubaneswar. The views are personal.)

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