Milton Friedman famously said, ‘Inflation is taxation without law.’ The effect of inflation – the overall increase in prices in an economy – is felt by all. High inflation affects the poor adversely. Therefore, individuals place expectations about how prices will behave in order to exercise caution in the future. If they anticipate high inflation, they negotiate wages or rent to compensate for a potential drop in their purchasing power. Increased wages raise the cost of production, make expectations self-fulfilling and, therefore, play an important role in determining inflation.
RBI on 8 April released the Inflation Expectancy Survey (IESH) of households for March 2022. The inflation expectations results are based on responses from nearly 6,000 urban households surveyed in 19 major cities. The release coincides with the completion of two years from the period of the first lockdown in March 2020. The surveys of the last two years, therefore, capture the perceptions of individuals during the three waves of COVID-19. The survey results offer interesting behavioral insights for public policy, particularly from a gender perspective.
high inflation expectations
When temporary price shocks due to drought or global supply chain disruptions increase the risk of transmission to real inflation, central banks raise interest rates to ‘anchor’ expectations of higher inflation. To what extent can an increase in interest rates dampen expectations of higher inflation? The factors behind inflation expectations should be carefully examined as any misstep can lead to wrong policy decisions.
An important factor shaping assumptions on inflation are the values that individuals observe in their daily lives, originally introduced by Robert Lucas in his seminal island model. A recent study by Acunto et al., 2020 confirms that agents who buy frequently, rather than what they buy often, shape their perception of the general level of inflation. Frequently purchased items such as groceries tend to be low-priced and highly volatile compared to seldom-purchased items. In other words, prices of lower-priced potatoes, milk, or apples often shape overall inflation expectations than repeated purchases of a higher-priced car. The economy can be confusing.
This insight has implications for gender-based differences in anticipating future inflation. Existing literature suggests that inflation expectations are higher among women than men. Economic theories explain this divergence by stating that women are ‘more pessimistic’ than men, attributing pessimism to their innate characteristics, lack of education, financial literacy and differences in preferences. However, a new study suggests that it is not innate characteristics as much as traditional gender roles that explain this divergence.
‘Natural Experiment’
To test its validity, the trends in the Inflation Expectancy Survey (IESH) before and after the lockdown period present themselves as a crude ‘natural experiment’. Natural experiments are real-life situations that can be studied to determine a cause-and-effect relationship between classes of people at different risk levels for an assumed causal factor. The authors speculate that if traditional gender roles are the primary reason behind the gender inflation expectation gap, then lockdown-imposed work-from-home (WFH) arrangements or loss of employment should contribute to closing this gap. Rationale: During the lockdown, people in urban areas lost jobs or stayed at home, taking a relatively equal share of everyday purchases.
Two categories of occupations are studied here: housewives (considered to be dominated by women) and employees in the financial sector (considered to be dominated by men). Looking at the trends in RBI’s surveys for the period between March 2018 and March 2020, housewives report higher inflation expectations than financial sector employees. However, this gap has narrowed in the last two years and almost converged in March 2022. One possible explanation for closing the gap could be the gradual ‘experience effect’ of male-dominated financial sector employees. Experience effect, in contrast to rational expectations theory, which holds that individuals base their decisions on information available to them, is based on the premise that actual personal experiences shape behavior more than they are informed about the outcome of the event. Huh. Therefore, a greater focus may be placed on microfoundation – understanding macroeconomic outcomes by studying individual behavior and the factors that shape decision-making – in order to make better policy decisions related to macroeconomic events.
(Bhaskar J. Kashyap is Assistant Director, NITI Aayog. Dr. Arup Mitra is Professor of Economics, Institute of Economic Development)