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Role and Impact of Inflation Targeting Regime on Households’ Inflation Expectation
The inflation targeting regime has almost no impact on households’ inflation expectation formation. The article finds a very high correlation between the three–month ahead households’ IE and current inflation perception. It argues that the IE majorly depends on households’ realisation of current inflation, providing very less space for other factors, like regime shift to IT. It further questions the fundamental need of awareness regarding the IT regime for it to affect the IE formation among households.
The “Expert Committee to Revise and Strengthen the Monetary Policy Framework” chaired by the Reserve Bank of India (RBI) deputy governor, Urjit Patel submitted its report in January 2014 with the recommendation to implement the inflation targeting (IT) regime in a phased manner in compliance with their inflation glide path. Under IT, the central bank sets an explicit medium–term inflation target and publicly announces it as part of its monetary policy. Although IT was informally implemented in April 2014 with a target to achieve an 8% inflation rate by the end of the year, it was formally adopted only in August 2016 with an inflation target of 4% with a tolerance band of 2% on both sides. Thus, an amendment in the RBI Act, 1934 provided a constitutional basis for implementing the flexible inflation targeting (FIT) framework, formally in India. The IT regime completed its first term of five years in March 2021 and is currently in its second term.
The inflation expectation (IE) is central to the mechanism of the IT regime, which represents people’s anticipation for the price increase in the future. The one–year ahead IE records what the respondent expects the inflation rate to be after one year, and likewise, the three–month ahead IE is respondent’s expectation of inflation rate after three months. The current inflation perception implies the inflation rate as perceived by an individual, which differs from person to person. In usage, it is different from both IE of the individual and the actual/realised inflation in the economy. Announcement of short–run inflation targets with the necessary credibility of the central bank to maintain the targeted inflation rate leads to the formation of individuals’ IE. With a lower short–run inflation target, the central bank anchors the IE at a lower level through the expectation channel. The actual rate of inflation declines with a declining IE and vice versa. This constitutes the core to the working of IT framework. However, the efficiency of the expectation channel and the credibility of central bank are the crucial determinants for the success of IT. More importantly, it requires the individuals to be aware of the short–term targets of the central bank.
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