The first-ever core inflation forecast by the RBI came as a surprise. A market request, according to the RBI governor, it does not represent any policy shift as headline inflation remained the target and primary goal, even as core inflation always figured in monetary decisions. He added that the different inflation components and their drivers were important and it was the right time — following the quinquennial review of inflation targeting — to share their internal core projections with the public.
From this it appears the core inflation forecast (CIF), which reflects demand dynamics, is an intermediate diagnostic. Its analytical service is to help markets/bond investors “look through” supply-driven headline inflation volatility — detect the signal from the noise, as it were.
Though a first for India, this practice is widespread across advanced and emerging economies with varying degrees of formality, a near- versus medium-term trajectory of inflationary pressures integrated with an explicit narrative on second-round effects, and how core informs but does not determine monetary decisions.
What are the implications for market expectations and anchoring? Does a CIF improve transparency and understanding but can create uncertainty and confusion about the future path?
There is the possibility that a supply-demand decomposition with separate projections will prompt guesses about the weights assigned to core at different stages of monetary policy decisions. An explicit CIF raises the salience of the measure, creating implicit expectations that it matters in a defined way. This introduces the risk of misreading the underlying signal. For example, inferring the RBI will not react to transitory supply-induced spikes — e.g. food, fuels, other cost shocks — to the headline but instead, calibrate policy to the underlying trend inflation, markets may not expect tightening or an aggressive response. This anchoring function may lower term premia, flattening the short end of the yield curve during supply shock episodes. Hence, markets can directly price disclosure of the RBI’s supply-vs-demand assessment into the term structure.
Whether the CIF is a pointer to future action — a forward rate indicator — is an open question, however. It depends upon information from the decomposed headline-core (H-C) gap, type of shock, and its longevity embedded in the projections and their accuracy.
Consider three possibilities: H >, =, or < C. The first is a classic supply shock — a temporary relative price shift that central banks “look through” — with the challenge of real-time distinction (temporary or enduring), duration (un)certainty, the timing, and degree of action, e.g., none, limited, or precautionary frontloading against the entrenchment risks. The second is unequivocal. The third can again pose difficulties because supply shocks like oil-commodities-imported inputs infiltrate quickly into core, questioning the clean demand signal from the persistent component of inflation (CIF).
History shows H-C inflation gap is not stable (see chart), which undermines its signalling properties, i.e. nature and persistence of supply pressures; hence, its discriminatory power and predictive ability. In 2019-24 for example, H stayed mostly above C with enlarged gaps — an average 1.98- and 1.48-points lasting above a year in October 2019-November 2020 and in July 2023-December 2024 — against a modest 60-bps wedge in January 2014-August 2016. Food inflation, averaging an annual 10.2 and 8.5% each month, was the prominent driver of the recent gaps.
These antecedents are important. Core inflation on average accounted for just 30% of the entrenched overall inflation, descended with alarming speed within one year to ~3.1% by mid-2024. Since January 2023, its pace is sober — an average 4.2% against a long-term 5.2%. Prolonged disinflation and the wait for a durable decline in headline inflation prompted internal MPC disagreement on the mounting growth sacrifice, ignited debate on headline’s relevance as inflation target in food shock-prone economies, while the RBI — which only completed a 250-bps, catch-up tightening in nine months (May 2022-February 2023) — confronted a difficult trade-off.
These remind that the old headache, food inflation — critical to inflation targeting’s adoption to anchor expectations — has returned to the centre of monetary policy, necessitating refinement of supply-shock treatment under the framework. CIF, the underlying trend inflation to which headline returns after shocks subside, fits here with careful communication and, possibly, improved policy outcomes as output losses are minimised.
The RBI’s assessment is that core is relatively stable against headline volatilities, with H converging to C in the long run. This contrasts with C-to-H convergence back in 2013-14. We must also reckon with the exceptional significance of wide-ranging, stringent supply measures — trade policy, direct agriculture market interventions, fuel tax adjustments, etc. — in the H-C dynamics in the high-inflation years of 2019-24. The extent and timing of these is unpredictable; fiscal risks spill over to bond yields.
Against this, markets may infer implicit response scenarios, decoding what the RBI’s policy rate path implies about different inflation measures. In instances of wide divergence, a comparison of dual inflation projections to discern the operative reaction function is not impossible. Crucially, if both forecasts are widely off the mark, it can be difficult for markets to anchor on either. An illustration is the sharp monetary policy turn —two-step, 90-bps tightening — in May-June 2022: a month before, inflation was projected falling from 6.3% in April-June by 50-, 40-, and 30-bps in the subsequent quarters, and 5.7% in 2022-23 without monetary action.
Actual headline accelerated to 7.0 and 8% in March-April 2022, while core rose to 6.5 and 8%. In June 2022, the upward quarterly forecast revisions were a staggering 120-, 160-, 80-, and 70-bps respectively, with annual inflation marked up 100-bps, 6.7%. This emphasises forecasting difficulties in different supply shocks — food or fuel-cum-input prices passthroughs to core with generalisation; the risks of possible underweighting in the baseline, the transmission process, and disinflationary impact of multiple, simultaneous supply actions of indeterminate quantum and timing outside the RBI’s control.
In the present context, i.e. Gulf shock, the third case — cost-push price pressures passed on by private sellers with or without fuel price adjustments by government — is particularly relevant. The price-cum-supply shock transmission to core via input costs, wages, and transport to prices of other goods and services could undermine the look-through rationale from the outset. This would question reliability of the demand signal as H and C both move in the same direction, creating ambiguity about monetary policy responses and market uncertainty about the relative weight assigned to core. Has the genie been let out of the bag at the wrong time?
The author is a Senior Fellow at the Centre for Social and Economic Progress
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.