Modeling heterogeneity and rationality of inflation expectations across Indian households

We analyze the inflation expectation formation of Indian Households using Inflation Expectations Survey of Households dataset, and draw out its implications for the effectiveness and use of the expectations channel of monetary policy transmission. Using quantitative responses we discover that households' expectations are adaptive and backward looking. They are not efficient. Food inflation has a significant short run impact but the effect of core inflation increases over the long run. There is considerable heterogeneity across households with females, daily workers, young and retired persons having higher inflation expectations than their counterparts. Unlike advanced economies, retired persons have higher expectations perhaps due to the accumulated information about higher inflation in the past, inadequate social security and underdeveloped pension schemes. Households do not overreact in comparison to the forecasts of RBI and professional forecasters. But short term reactions are significant and heterogeneous across households. The large speed of adjustment, absence of over-reaction, low response coefficients to commodity shocks in a simultaneous and impact of the RBI's forecasted path bodes well for successfully anchoring household inflation expectations in the process of inflation targeting, but requires that these forecasts are carefully made with a focused use of the expectations channel. Communications have more of an impact on inflation expectations than the interest rate. A repo rise actually raises inflation expectations pointing to the ineffectiveness of the aggregate demand channel and of aggressive rate rises.