When we talk of inflation that is targeted by the Monetary Policy Committee, the reference is to the Consumer Price Index. This is the global practice where the idea is to gauge retail inflation that affects individual households.

This is why policy has moved away from WPI, which is closer to a producer price index, to CPI. The present form of the index as a reflection of the state of consumer price inflation has become a subject of debate with two schools at work. One argues that the index needs to be rebuilt with less emphasis on food which will actually smoothen down inflation.

The other holds on to the view that the present index does not capture the true inflation as the people who are most affected by it — that is, the households — believe the number is much higher. How can these two views be reconciled as there is merit in both of them?

In this context, it would be pertinent to examine the RBI household inflation expectation surveys. This is done on a bi-monthly basis and covers around 6,000 households in 19 cities with the gender spread being even. The sample households are polled on what they believe is the inflation rate as well as their view three months and a year ahead. Here the results are interesting as there has been a tendency for these conjectures to be substantially higher than the official CPI inflation numbers.

Household perception

Since September 2009, the household perception on a bi-monthly basis has always been above 6 per cent. Of the 76 observations, on 57 occasions the number is above 8 per cent. As late as FY24, the households had a median number of 8.4 per cent when the official inflation figure was 5.4 per cent. And for the current financial year, for the two points covered so far, perception has averaged 8.1 per cent against 4.2 per cent as per the official estimate. The difference of above 300 basis points (bps) is interesting.

To understand this phenomenon, it is necessary to differentiate between price levels and inflation. Inflation is the rate of change in prices. Hence even when it said that inflation is coming down from say 6 per cent to 4 per cent, prices are still increasing, albeit at a slower rate. This is why the phenomenon of inflation coming down may not be comforting to individuals unless it turns negative, which rarely happens. How then can one explain the way individuals form perceptions of the inflation rate?

First households look at prices rather than the inflation number as this is what they confront in the market. When prices are rising, they calculate the increase in their budgets and determine the true inflation rate. There is hence a ‘practical’ bias here which will look more at prices that have increased rather than those which were unchanged.

Second, often single commodities can cause a more general view on prices and inflation. The most recent episodes of onions or tomatoes becoming dearer in the market brings in a visualisation of high inflation even though it could be restricted to a couple of commodities. Arhar dal, onions, tomatoes and potatoes fit the bill here. Hence, there is a ‘single product’ bias here.

Third, often numbers matter. This holds for commodities which cross commonly perceived benchmarks. Hence, it is believed that petrol is expensive because it costs over ₹100 a litre in most places. For a long time governments were hesitant to let the price cross the ₹100 mark as that had become a ceiling. Hence the ‘benchmark or ceiling’ bias holds for several products where the mind is tuned to the fact that once this mark is crossed, life becomes difficult.

Fourth, there are ‘daily’ biases which also come in. These inclinations come in inadvertently when it is realised that very often the price of milk has been raised — even by say, ₹2 a litre. Earlier price hikes get embedded in the system, and it is easy to conclude that milk price is rising even though the last raise may have been a year back. This gets amplified when one looks back over days when milk was just ₹20 a litre as against ₹56/litre today for a branded pack.

Fifth, there is a ‘shock’ bias which comes in when it comes to services. Here one can look at the logistics partner in food delivery which increased the charges for the service that came at a lower price earlier with discounts thrown in. Once the market price has to be paid, the shock factor gets embedded in the mind leading to inflationary perceptions building up.

Not tracking prices

Similarly, hotel tariffs, air or train tickets during holiday season will be high when surge pricing kicks in, compared to off season, so it would be easy to conclude that inflation is high.

Last, there is ‘immediate recall’ bias where consumers compare price increases with the time period when they were stable. Hence the year-on-year basis of official calculation can be ‘misleading’ for consumers. Households are unlikely to remember the price in September 2023 but would benchmark any change in September 2024 over, say, May or June when the price was at a lower level.

All these biases normally work when prices are increasing, so it is easy for people to perceive inflation to be above 6 per cent all the time.

This gets fuelled by the fact that invariably some products and services in these buckets would be witnessing sharp increases in prices.

On the other side a CPI component like housing which has a weight of 21.7 per cent in the urban inflation basket is unlikely to influence the household perception on inflation.

This is taken more as a fixed cost of living and often adjusted in the salary component of house rent allowance. Therefore, when there is a change here, it will not be in the mind space of the respondent.

The variation in the perception and formula-driven calculation of inflation does raise an issue of what the MPC should target.

The formula-driven CPI is not the one people in general associate with and is hence more a policy-driven variable. But gauging inflation through such surveys turn out to be very subjective. Therefore, opinions will be divided when inflation numbers officially come down even as the household purses could still be under strain.

The writer is Chief Economist, Bank of Baroda. Views are personal