Monetary Policy: What To Expect When You’re (Not) Expecting...

There is a widespread consensus that the Monetary Policy Committee will cut rates this week. But, as previously discussed, the outlook for monetary policy over the next year will depend crucially on whether (benign) headline inflation converges to (sticky and elevated) core inflation, or the other way around. In turn, however, the directionality of convergence, will depend crucially on the evolution of inflation expectations in India.

The conventional wisdom is that household expectations are largely driven by food and fuel prices. The corollary, therefore, is that sustained food disinflation over the last few years should have pulled down inflation expectations and, in turn, this should have a salutary impact on core inflation.

The data and evidence are, however, at odds with this hypothesis. First, both 3-month and 12-month ahead inflation expectations have been disconcertingly sticky over the last few years, currently at levels that existed a year or two ago, despite the dramatic undershoot of food prices.

In contrast, gasoline has no economically or statistically significant impact on inflation expectations. These findings run completely counter to the conventional wisdom that food and fuel are the primary determinants of inflation expectations, and instead point to the importance of core inflation.

Our findings throw up several implications.

1. They help us understand why core inflation has been so sticky and persistent.
2. They help explain our earlier findings of why headline converges to core in India – because inflation expectations are being shaped by core inflation, rather than food and fuel.
3. The common presumption that core inflation will soften—holding slack constant—through an inflation expectations channel is unlikely to materialise.

Whether the opposite happens—and food begins trending up to core—however, will depend on how quickly output gaps close and wages firm. Economic forces apart, as recent months have revealed, the political-economy of India is unlikely to tolerate the terms of trade confronting farmers to remain at these depressed levels. One can therefore reasonably presume that efforts will be made by the next government – whether through cash transfers, minimum income guarantees or opening up exports – to push up food prices, and thereby alleviate the stress confronting farmers.

A Rate Cut Now, But Then What….

In cutting rates at the last policy review, the MPC noted that monetary policy would be conditioned on its legislated mandated of keep headline CPI close to 4 percent on a durable basis. With the RBI’s 12-month ahead CPI forecast dipping below 4 percent, the MPC pulled the trigger in February. The continued undershoot of food prices (vis-à-vis expectations) is likely to induce another rate cut at this week’s review. Indeed, markets are now progressively expecting the rate cut cycle to extend beyond April.

Core-core inflation (standard core adjusted for petrol, diesel and housing) continues to remain sticky and elevated: averaging almost 5.5 percent over the last 12 months and accelerating further to 5.9 percent in February. Furthermore, the hardening of core-core inflation is broad-based, with 5 of its 6 sub-components at 5 percent or above. Separately, while food inflation appears to be gradually emerging from contractionary territory – printing at minus 0.1 percent in February over the previous year versus an average of -1.5 percent over the previous three months – the gap between core-core and food remains exceptionally large.

As we have previously postulated, the outlook for inflation and monetary policy over the next year will therefore come down squarely to whether headline begins to converge to core or vice-versa.

If core inflation progressively begins to soften and asymptote towards a benign headline print, markets will start pricing in a much longer easing-cycle. Conversely, if food—and therefore headline—starts heading towards core, rate cuts will quickly get priced out, and incipient worries about rate hikes will emerge.

The Importance Of Inflation Expectations

This much is now well known. What’s important to recognise is the crucial role that inflation expectations are likely to play in determining the direction of convergence. For starters, various studies find that inflation expectations play an important role in the determination of inflation in India, through the New Keynesian Philips Curve channel.

The question, therefore, is what factors influence household inflation expectations in India? Expectation formation is typically a hybrid of rational (forward looking) and adaptive (backward looking) impulses. That said, in India’s case several studies find

• a meaningful adaptive component and,
• more importantly, that food and fuel prices are key drivers of household inflation expectations.

Lower inflation expectations, in turn, should have a salutary impact on core and headline inflation, through the aforementioned Philips Curve. So the conditions should be in place for core inflation to soften towards much lower headline inflation. Right?

Puzzle: Household Inflation Expectations Remain Disconcertingly Sticky

Not so quick. The RBI’s household survey of inflation expectations reveal that, contrary to popular perception, inflation expectations have been remarkably, and disconcertingly, sticky.

To be sure, expectations saw a sharp downshift in 2014-15, ostensibly responding to headline CPI inflation halving between 2013 and 2015. Since then, however, inflation expectations have been remarkably sticky, despite inflation trending even lower and food inflation, in particular, collapsing in recent years. Yes, much can be made about the fact that 12-month-ahead expectations have softened by 150 bps over the last two quarters. But, at 8.5 percent in December 2018, they are at exactly the same level they were 12-months ago and 24-months ago. Similarly, 3-month ahead expectations softened last quarter but, as of December 2018, were still higher than 12 and 24 months ago. This, despite food inflation falling by almost 400 bps over the last three years.

So What Drives Inflation Expectations?

So what’s going on? Why haven’t inflation expectations responded to lower food and fuel prices – as is commonly presumed and found in previous studies?

To investigate this puzzle, we explicitly model household inflation expectations, as a function of the different components of inflation – food, fuel and core. This acknowledges both the adaptive nature of expectations as well as tries to ascertain the relative importance of different sub-components of inflation in driving expectations – a question that should gain particular currency given the wide divergence across food and core.

We, therefore, estimate the equation below, in differences:

Inflation Expectations ~ Constant + α(Food) + β(Core) +δ(Fuel) + γ(Gasoline) + ε

We alternately use both the 3-month and 12-month-ahead expectations. Food and Core refer to food inflation and core inflation respectively. Fuel refers to the fuel index in the CPI basket. However, because this index does not include gasoline and diesel – which are instead included within services, we separately include a ‘Gasoline Index’, comprising a weighted average of petrol and diesel prices.

Results: Core Inflation Matters Thrice As Much As Food!

So what do we find? First that, contrary to conventional wisdom, core inflation influences household inflation expectations three times as much as food!

Second, that gasoline inflation has no statistically, or economically, significant impact on expectations. These results are particularly true of the 12-month ahead inflation expectations, thereby overturning the conventional wisdom that food and fuel are the key determinants of household inflation expectations in India.

This result is robust to choice of different control variables in our estimating equation as well as to different time periods.

We also get much the same results using 3-month ahead inflation expectations, instead of the 12-month ahead expectations. While, the coefficients on food and core are slightly lower, core still matters three times as much as food. That said, core inflation is statistically significant at the 12 percent level, rather than the 10 percent levels when using 12-month ahead expectations.

Finally, since the household survey is an urban one, we replicate the same results using the Urban CPI. Qualitatively, we get the same results when using 12-month ahead expectations. The coefficient on core is almost three times as much as that on food, though it is significant at a slightly lower level (12 percent level versus the 10 percent level in the baseline result, for the combined CPI). The Gasoline Index remains economically and statistically insignificant across all specifications.

One implication of these results is that while food inflation may shape expectations at the 3-month horizon (since the role of core is marginally less statistically-significant at this horizon), it’s core inflation that decisively shapes expectations at the 12-month horizon – the horizon that likely matters for central banks given the “long and variable lags” associated with monetary policy.

This Explains Why Inflation Expectations Have Been So Sticky

Our findings can therefore help explain why inflation expectations have been so sticky in recent years. Food inflation has fallen by more than 300 bps over the last two years which – even by our own results -- should have had a depressive impact on expectations. But core inflation has accelerated by about 100 bps during that time period and, because, the impact of core is three times that of food, our results suggest that accelerating core has largely undone the impact of food, thereby keeping expectations sticky.

The Bar For Core To Converge To Headline Just Got Higher

A number of implications flow from our findings. First, they help explain why core inflation has been so sticky.

Second, they help us make sense of our earlier finding – that in recent years its headline that converges to core and not the other way around. This is because, if headline inflation is ultimately driven by ‘inflation expectations’ and ‘slack’, and

• slack influences core; and
• core influences inflation expectations, its no wonder that headline converges to core.

Third, the forces that are commonly assumed – that food and fuel will pull down inflation expectations which, in turn, will pull down core – are unlikely to work, given our findings. For core to soften materially, growth will have to slow and output gaps will have to open up.

All this raises the bar for core to soften to headline.

What Will It Take For Headline To Head Towards Core?

The key is what dynamics could push food towards core inflation? The typical transmission should occur through wages. As output gaps close, wages should start firming up. This should put pressure on food prices through both a cost-push channel (as agricultural wages eventually firm up) and through a demand channel (as higher wages boosts demand for food). Are we see first signs of that, already? Rural wages have stopped decelerating and, particularly agricultural wages, have begun to tick up. Also, food prices have sequentially increased (on a seasonally adjusted basis) for three consecutive months, for the first time since the last quarter of 2017. WPI food inflation has accelerated much more sharply. Will CPI prices follow suit?

Economic channels apart, as the last few months have revealed, the political-economy of India is unlikely to tolerate the terms of trade confronting farmers to remain at these depressed levels.

One can therefore reasonably presume that efforts will be made—whether through cash transfers, minimum income guarantees or opening up exports—by the next government to push up food prices, and thereby alleviate the stress confronting farmers. There are, therefore, both economic and political-economy reasons to expect food inflation to gradually re-accelerate, though this could take a while.

All this suggests we should not take the currently benign inflation trajectory for granted. The current may not be a particularly good predictor of the future.

Sajjid Z Chinoy is Chief India Economist at JPMorgan.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.