In the last three to four years inflation control has become the dominant theme of our monetary policy. Growth has received scant attention and of even lesser concern has been the issue of employment. Taming inflationary expectations has become a near exclusive fixation for policy-makers. The current approach fails to incorporate lessons from the recent advances in behavioural economics.

Inflationary expectations have stayed stubborn at 8-10 per cent even while CPI inflation has been drifting downwards to 3-4 per cent for several months. There are some fundamental issues with expectations of individuals.

Some loose ends

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 the RBI itself has been consistently overestimating inflation.

Secondly, the 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. The RBI does not reckon the purchase cycle.

Thirdly, there is the nature of human mathematical comprehension itself and translation thereof into annual numbers. Even if consumers knew rightly that the weekly inflation rates of two different items are 0.2 per cent and 0.5 per cent, they will most likely come up with annual numbers in the region of 6-10 per cent (instead of 11-30 per cent). The 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. Vegetable prices vary by as much as 40 per cent 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 per cent 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 per cent annual inflationary expectation in real estate might make many to advance their purchase of a house sooner than later more so if the financing costs are lower. But the same inflation expectations for petrol and diesel prices (roughly 1.12 per cent on monthly cycle basis) may not make a car or two-wheeler owner to tank up to cover his next purchase. The same rate (0.264 per cent 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 the 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 end of season sale — upwards of 15-20 per cent and in the case of some items 40 per cent or one free for every one purchased, and so on.

One does not hear of 1-2 per cent off on discount sales open only for 1-2 days (a 2 per cent discount ending in two days translates to a cumulative 3,500 per cent per annum) 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 per cent annual interest rates.

Unless inflationary expectations translate to rational choices by consumers, the current approach will on most occasions result in excessive action. And as the RBI’s data clearly prove, as far as India is concerned, inflationary expectations are not necessarily rational expectations. Only when inflation becomes high (say, 20-25 per cent 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 per cent seems like having a foot firmly on the brake pedal as a precautionary measure while driving at one kmph. Actually many end-products in the agri and manufacturing sectors are crying for better prices to neutralise their cost increases.

Differentiated approach

There is good case for junking the focus on inflation control while drafting the monetary policy. Even in the short run our economists would be forced to concede that low inflation is a major cause for the current unemployment crisis. We can just use the last two months’ or quarters’ inflation to decide whether it is necessary convene the review meetings at closer intervals.

Rather than a single objective , we should use a differentiated approach depending on the levels of inflation. Up to 4-6 per cent inflation we should focus on job creation, between 5-8 per cent on growth and employment, and thereafter inflation control can take primacy.

Our industrial capacity utilisation is stuck at about 75 per cent for a long time now. The lowest hanging fruit to be harvested for employment and growth is to put the unutilised 25 per cent to use. It would take a bold approach to identify the more viable ones amongst these and provide them with 4-6 per cent working capital, which could get them chugging again. An additional 2 per cent growth will deliver more goods and services to the consumers and tame inflation and create employment far better. But such an approach would be blasphemous to the orthodox theorists.

The writer is CFO JK Paper and author of ‘Making Growth Happen in India’

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