In March 2009 the inflation rate based on the wholesale price index stood at 1.2%. A year later, it is expected to be about 7%, well above the RBI?s loosely-defined inflation target of 5% for WPI inflation. In the first quarter of 2009, the economy expanded at the rate of 5.8% year-on-year. A year later, it is expected to grow close to its trend growth rate of 8% per annum. With inflation expected to overshoot the central bank?s comfort zone and economic growth expected to be on track, the RBI in normal circumstances would be expected to tighten policy to bring inflation back on track. However, the extent and sustainability of the current phase of economic recovery is far from certain. Given this scenario, should the RBI tighten monetary policy in its forthcoming review scheduled for the end of this month?

Central banks the world over use market participants? survey about future economic outlook and in particular their expectations on the inflation front as an important input in the monetary policy decision process. Inflation expectations are important since many decisions are influenced by it. For example, if inflation is expected to rise, employees try to renegotiate wage contracts, and as the costs escalate firms would try to pass it on to consumers, thereby increasing the price of final goods and services.

Since 2007, the RBI has conducted a quarterly survey of professional forecasters for key macroeconomic variables, including WPI and CPI inflation. Examining data from various rounds of this survey allow us to track changes over time in the market participants? outlook for inflation. The participants in the RBI survey are economists who are well aware that general inflation is distinct from a rise or fall in the price of individual commodity. That is, they know the difference between absolute and relative price changes. Individual prices rise and fall all the time in a market economy, reflecting consumer choices and preferences, as well as supply shortages for a particular commodity.

In contrast, inflation is an increase in the general price level (a weighted average of all goods and services in the consumption basket). The survey participants therefore are unlikely to conclude that the rapid increase in agricultural prices that we are currently experiencing would translate into permanently higher inflation unless the underlying monetary regime lacks credibility. That is, if the monetary regime is credible, market participants would expect supply shocks to have transitory effect on inflation, leaving their medium and long-term inflation projections largely intact.

What does the data from successive rounds of the RBI?s survey of professional forecasters suggest on this score? The chart presents the difference between one and two-quarter ahead median inflation forecast from each survey and the realised WPI and CPI inflation rates. It is clear that the survey participants have tended to under-predict CPI inflation while the evidence with respect to WPI inflation is some what mixed. Furthermore, forecast errors in both WPI and CPI inflation are significantly lower for the one-quarter ahead forecast vis-?-vis two-quarter ahead forecast.

What explains this? It is likely that the shocks affecting inflation in recent years were either difficult to predict or its magnitude and persistence were difficult to gauge a priori, making inflation difficult to forecast. For example, survey participants on average appear to have under-predicted the magnitude and persistence of shocks hitting the agricultural sector. As a result they have tended to underestimate CPI inflation where primary commodities have a significant weight.

It is common knowledge that short-term forecasting is a notoriously difficult task. Medium term forecasts are far less so since they predominantly depend on the credibility of the underlying monetary regime. As Fed chairman Ben Bernanke points out, ?If the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored. If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.?

In recent years the RBI has increasingly emphasised on the importance of credibility in anchoring inflation expectations. What does the RBI survey have to say on the medium term inflation outlook? In the recent rounds of the survey market participants have upwardly revised their inflation forecasts for the next five years (see chart). Moreover, these expectations are volatile with frequent revisions. Revisions to the markets longer term inflation outlook, especially above the RBI?s indicative target of 5% inflation in the medium term, suggest a credibility deficit. It appears that survey participants believe that the temporary shocks hitting the Indian economy currently are likely to have a permanent effect on inflation going forward. Although not presented here, survey-based GDP growth expectations over the medium term haven?t undergone a substantial upward revision. Upward revision of expected inflation without a similar upward revision in GDP growth forecast is clearly a matter of concern.

At present, the RBI like most other central banks faces a challenging economic environment with the extent and sustainability of the current phase of recovery uncertain. The optimal monetary policy response is far from obvious. Nevertheless our analysis suggests that because of a credibility deficit tighter monetary policy should come sooner rather than later. This assessment should, however, be treated with some caution. Given the short sample period it is too early to evaluate whether these forecasts are unbiased and efficient. Moreover, until the realised inflation series is available for the medium term no proper assessment can be made. Hence the observations made here are at best tentative.