Under India’s inflation targeting framework, the government has mandated the RBI to keep inflation within a narrow band of 2-6%, with a midpoint target of 4%. But one of the less-discussed challenges for the Monetary Policy Committee is the ability to reliably estimate what inflation will be in the future, not just measure what it is today.
Future inflation is shaped by the usual suspects: demand-supply mismatches, supply shocks, global commodity prices. But there is another, less tangible determinant that carries just as much weight, which are people’s expectations. What people expect inflation to be has a significant bearing on what inflation actually becomes, in an almost self-fulfilling fashion.
The mechanics are straightforward. If people expect prices to rise sharply in the coming months, they negotiate higher wages today to protect their purchasing power. When wages rise across the board, household incomes go up, demand increases, but supply doesn’t immediately follow and so prices rise. The expectation of inflation produces the very inflation that was expected. Firms also rise prices preemptively in expectation of inflation and to cover the increased costs due to higher wages. Therefore, for a central bank understanding, measuring and managing expectations is an important task in managing inflation.
So how does a central bank measure expectations? The US Federal Reserve has several tools at its disposal. The most important are Treasury Inflation-Protected Securities or government bonds whose principal is indexed to CPI. By comparing yields on TIPS against regular Treasury bonds, analysts can extract the “breakeven inflation rate”: what financial markets collectively believe inflation will average over 5, 10, or even 30 years.
Alongside TIPS, the US also has a deep market in inflation swaps, which are derivatives where one party pays a fixed rate and receives actual realised inflation in return. The rate at which this swap is priced reveals, in real time, what sophisticated market participants are betting inflation will be.
An inflation swap is a contract between two parties who are, in effect, betting against each other on what inflation will turn out to be. Say a bank and a pension fund enter into an inflation swap. The bank agrees to pay a fixed rate of 4% per year on a notional amount, say ₹100 crore. The pension fund agrees to pay whatever inflation actually turns out to be over that period. At the end of the contract, only the net difference changes hands. If inflation comes in at 6%, the pension fund pays the bank 6%, and the bank pays the pension fund 4%, so the bank receives a net 2% on ₹100 crore. If inflation comes in at 3%, the bank pays out a net 1%.
India has neither. What the RBI relies on, primarily, is its Inflation Expectations Survey of Households, a bi-monthly questionnaire. The results are quite unreliable though. In 2025-26, surveyed households reported perceived inflation of around 7.2%, while actual CPI inflation averaged 3.3%, which amounts to a gap of nearly 4 percentage points. Research shows that Indian households form inflation expectations by looking backward at recent grocery prices, not forward at macroeconomic conditions. They are, in effect, measuring the price of tomatoes, not the trajectory of the economy.
There are real policy consequences due to this. If the MPC takes an upward-biased survey at face value, it risks keeping interest rates higher than the underlying inflation situation warrants. Tightening credit conditions unnecessarily for businesses and households, which will dampen the economy.
To fix this, India’s financial markets needs to be developed better. It requires the deepening of the institutional investor base, expanding inflation-linked government bonds, and building the derivatives ecosystem that makes inflation swaps viable. That is not entirely under the mandate of RBI, but is crucial for RBI to do its job.