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Inflation Convergence and Anchoring of Expectations in India
Careful research on the inflation targeting regime’s impact on anchoring inflation expectations, as well as an empirical examination of convergence, is used to assess the direction of convergence between core and headline inflation, as well as the efficacy of the expectation channel compared to the aggregate demand channel of monetary transmission. There is evidence of more anchoring, with the Reserve Bank of India communications as well as headline inflation affecting short-run inflation expectations and core inflation dominating in the long run.
The authors thank the anonymous referee whose comments greatly improved the paper.
The direction of convergence between headline and core inflation and its probable impact on the future course of monetary policy is a debated issue. Our objective is to distinguish between these convergence hypotheses, as well as the efficacy of the expectation channel compared to the aggregate demand channel. This is attempted through careful research on the inflation targeting regime’s impact on anchoring inflation expectations and an empirical examination of convergence, in order to contribute to the debate.
Anand et al (2014) argued that Indian headline inflation affected core inflation over the 1996–2013 period. Food and fuel shocks had persistent effects on inflation, through second-round effects on wages generalised through sticky inflation expectations, and therefore, a long period of tight monetary policy would be required to reduce inflation. The argument was influential in the Reserve Bank of India’s (RBI) choice of headline inflation as the inflation target and the implementation of strict information technology (IT), although what had been adopted was flexible IT.
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