Taming Inflation by Anchoring Inflation Expectations

By firmly anchoring inflation expectations, monetary policy can prevent a wage-price spiral and moderate the second-round effects of supply shocks, thereby avoiding an inferior macroeconomic outcome of lower growth and higher inflation. Using bias-adjusted survey data on household inflation expectations and an estimated inflation expectations anchoring index for India, this paper shows that the anchoring performance has improved notably following the adoption of the flexible inflation targeting monetary policy framework in India; the risk of a wage-price spiral moderates with firmer anchoring of inflation expectations; and that bias adjusted household expectations hover in close alignment with the headline inflation, besides exhibiting superior inflation forecasting properties.

Securing durable disinflation has been a global policy challenge since early 2022. The synchronised global monetary policy tightening that is in action now has generated an animated debate on its speed, magnitude, and duration, dividing the informed opinion between a “soft landing” versus a “hard landing” as the unavoidable cost of disinflation, even as easing supply chain pressures, softer commodity prices, and signs of greater resilience of the economies to adverse shocks have reduced the possibility of the latter. The risk of successive supply shocks raising inflation expectations and inducing second-round effects to cause a generalisation of the inflation process, with higher persistence, has all along been a key factor in shaping the conduct of monetary policy, and more so in the context of the current episode of a global surge in inflation. “Today’s inflation expectations are likely to become tomorrow’s inflation reality” (Grigoli 2023). Along with demand management, therefore, an emphasis on anchoring inflation expectations is critical for monetary policy to tame inflation (IMF 2023). The emphasis of monetary policy on maintaining well-anchored inflation expectations is “a bedrock principle of modern central banking” and evaluation of inflation expectations “should take a central role in monetary policy decisions” (Mann 2022; Williams 2022).