Household inflation expectation: Rarely in sync, yet a key policy driver

There will always be a gap between actual inflation and household expectation. Yet the latter is broadly indicative of trends and is a critical input for controlling prices

Every two months, the Reserve Bank of India does a survey of nearly 6,000 families in 18 cities to ascertain their expectations of where consumer inflation is headed. It records how households are thinking about inflation in three time frames: the current situation, three months down the line, and a year down the line. 

In its most recent data capture, it found that Indians are expecting inflation to moderate three months from now, and a year from now as well. Actual inflation too has softened, and is expected to moderate as supply constraints are easing, and unless food shortage plays spoilsport, the steadiness in inflation may stay. 

But how accurate are households when it comes to assessing inflation in the future? Do their expectations hold true in reality? Do expectations tell us more about the economy than just inflation? 

Households generally think inflation is higher than what the National Statistical Office finds in its monthly inflation measurement exercise. In September 2021, while households experienced inflation (median) at 10.2 per cent, the actual inflation turned out to be 4.28 per cent. 

But this difference, though huge, is not the point. The point is that both expectations and actual inflation follow nearly a similar pattern--similar movement but at different levels. 

In this regard, inflation expectations especially at the three-month and one-year level help a lot. Chart 1 shows that the similar patterns were more pronounced in the period before Covid-19. 

Then, there are periods where inflation expectations and actual inflation move in opposite directions. This has a lot of reasons associated with it, but as food occupies 45 per cent weight in the consumer price index basket, volatility in vegetables, pulses and the likes, due to erratic rainfall, or sudden fuel price increases, affects actual inflation more than expectations. 

This could be the reason why the actual inflation is looking down at the moment, but household expectations are still up. 

Expectations, experts say, are based on how spending individuals in households think about it. The theory goes something like this: If people think their incomes are going to take a hit, they will think that inflation is going to rise. With this in mind, they will ask their managers for a higher growth in their wages. If companies comply, they will add this as a cost to their products or services, and further raise prices in the economy, potentially fuelling inflation.

“Inflation expectations determine consumption behaviour of households and the wage-price cycle. In other words, a situation where employees demand higher wages to compensate for higher inflation expectations, and companies hiking prices to compensate for higher wages,” said Sreejith Balasubramanian, economist at IDFC Asset Management. 

Higher expectations on inflation mean a decline in consumption in months ahead, said Devendra Pant, chief economist at India Ratings, a corporate ratings agency. 

“If income growth has settled on a lower normal and inflation has remained high for some time, households think that it is going to pinch their pockets in coming months. In the first such instance, households may dip into their savings or borrow to spend. But if this happens again, households cut spending to maintain their savings,” he told Business Standard. 

Inflation expectations thus play an important role in household consumption decisions. This, he said, forms an important input for the RBI’s rate-deciding monetary policy committee. 

The chart above shows how inflation expectations have moderated in September 2021. But it shows something more than that. 

Inflation expectations rose sharply towards the end of 2019. The year was a witness to the exacerbation of the economic slowdown that began after demonetisation. When this bout of expectations mellowed, Covid-19 hit the economy, and due to nationwide restrictions, households further thought inflation will rise. 

Similarly, when India went through the second, and a deadlier wave, of coronavirus, inflation expectations of households rose again. 

Even now, even though expectations for the three-month and one-year horizon seem to have moderated, current inflation expectations are flat compared to recent months. Households are expecting stress in the economy--and their monthly budgets--to continue currently, but to eventually moderate in months from now.