Managing expectations

- Ila Patnaik

Financial Express, April 29, 2006

Dr Reddy got a lot of praise when he did not raise rates in Credit

Policy 2006-07. Ironically, the credit policy statement is full of

indications that RBI perceives inflationary expectations to be

high. This view on future inflation appears inconsistent with the

decision to keep rates unchanged. Saying that RBI will keep a watch on

inflation, and act when the need arises will confuse the public and is

not the best way to manage expectations and conduct monetary policy.

Most of us do not run models to forecast inflation. But we believe

central banks do. If inflationary expectations were actually low

before the credit policy announcement, there are few who would not

have revised their opinion after reading the policy statement. RBI has

made a convincing case for expecting higher inflation. The impact of

higher world oil prices has not seen a complete pass through to

domestic prices in India, but it has to happen. There may not be

clarity on when the inflation rate will go up, but after reading the

statement one comes away with the distinct feeling that inflation

rates are on their way up.

Life is not easy for central bankers. Based on a variable that is not

observed -- inflationary expectations -- they have to use instruments

like interest rates that are known to impact inflation after about at

least a year and a half. RBI has to choose from a number of

instruments available to it -- the Cash Reserve Ratio, the bank rate

and the repo rate. Moreover, it has to use flawed measures of

inflation rates, whether based on WPI or CPI, whose data is collected

by other agencies and which do not offer a clear picture for decision

making. The Government of India has further burdened the RBI by

imposing upon it the tasks of public debt management, currency

management and banking regulation, which often have conflicts with the

conduct of monetary policy.

However, despite the difficulties, in recent times central bankers

have been increasingly successful in the conduct of monetary policy by

managing expectations. For example, when Alan Greenspan felt that

inflation in the US was rising and interest rates should go up, he

made many speeches saying so and then followed them by raising

rates. The Bank of England has managed expectations by setting up a

transparent mechanism -- the Monetary Policy Committee -- which is

given an inflation target and which puts up the minutes of its

meetings on its website. This allows people to know why certain

decisions are being taken and to know what to expect.

Why is it important to manage expectations? Primarly because the

effectiveness of monetary policy depends on what the private sector

expects from it. The research on rules vs discretion, credibility and

time consistent policies, inflation targeting and Taylor rule, all

agree on one thing. That the private sector factors in what it

believes is the central bank's policy and that makes all the

difference to the impact of central bank policies. When households and

firms make decisions, the outcomes are much better when interest rates

move as expected. The credibility of the central bank is of utmost

importance. Private agents form expectations and make decisions based

on what rules, explicit or implicit, they expect the central bank to


Credit policy 2006-07 leaves Dr Reddy with a difficult task. His

policy document makes it very clear that inflationary expectations are

high. Yet, he did not hike rates. As a consequence, people can no

longer expect that if the RBI perceives inflation to go up, it will

hike rates. Listening to the RBI for the last few months had created

expectations that rates would go up. Even one hour before the policy

there was confusion -- half the analysts on TV were saying rates would

go up, the other half were hoping they would not.

What should be done now? The internal decision to raise or not raise

rates in July (or before that) should not be left until then. Within

the RBI it should be made now. Then, if he is going to raise rates, Dr

Reddy should say so, and keep saying so again and again till people

are sure that he will, and then come July, he should raise them.


Back up to Ila Patnaik's media page