Inflation Expectations and Portfolio Rebalancing of Households: Evidence from Inflation Targeting in India

This paper exploits a natural experiment in India – Inflation Targeting to study how changes in inflation expectations influence households’ consumption, savings, and investments in risky assets. Using regional heterogeneity in inflation expectations by city and city-age-gender bins due to the Inflation Targeting policy, we provide evidence of portfolio rebalancing. A decrease in inflation expectations by 100 basis points led to a decrease in risky investments by 2 percent and a larger increase in bank deposits by 22 percent. This suggest that households shift their assets away from risky assets to safe assets when there is a fall in inflation expectations. Households with more liquid wealth have larger decreases in both consumption and risky investment. We attribute our findings to the nominal rigidity of the savings deposit rate: changes in inflation expectation have asymmetric impact on nominal returns, and thus leads to the asymmetric impact on real returns of risky and risk-free assets. These results highlight the relationship between inflation expectation and nominal rigidity in household balance sheet.