Monetary policy in 2018: Targeting inflation in uncertain times wasn’t easy

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Updated: Dec 25, 2018 3:15 AM

MPC’s predicaments were palpable as most elements remained misaligned. But, can anyone really predict Food CPI for thenext 12 months correctly?

monetary policy, indian industry, fdi, fpi, inflationThis was because headline inflation, pulled down by sharp undershooting of food price inflation, masked adverse movements in the underlying trends of other key elements of a comprehensive inflation targeting (IT) regime.

Looking back at the eleven-month (January-November 2018) trend in CPI-headline inflation, one is tempted to believe the MPC’s decisions must have been relatively easy ones. With headline inflation averaging 4.13% or nearly at the midpoint target of 4%, the committee must have stayed on hold with a dovish stance and the policy rate well below 6%! Far from that though. The MPC in fact raised the repo rate twice to 6.5% and changed the stance to’calibrated tightening’! This was because headline inflation, pulled down by sharp undershooting of food price inflation, masked adverse movements in the underlying trends of other key elements of a comprehensive inflation targeting (IT) regime.

Put yourself into the shoes of MPC members and look at each element of a simple IT framework as the year 2018 evolved: (i) output gap was closing or completely closed; (ii) inflationary expectations were rising, with one-year ahead expectations closer to 10%; (iii) core inflation with all kinds of adjustments made by analysts stayed above 5% or even closer to 6%. Add to that rising oil prices, a persistently weakening rupee, hawkish US Fed and tightening global liquidity and you’d quite certainly sympathise with RBI researchers against the barrage of criticism for persistent errors in their inflation forecasts and thereby keeping the real rate much higher.

As 2019 unfolds let us focus on three outstanding features that marked monetary policy in 2018. One, the unpredictability of food prices that caused much of the undershooting in RBI’s inflation forecasts. Two, the unstated concern about rising core inflation that troubled RBI and which underpinned its projected inflation path. And three, the unchanged elevation of one-year ahead households’ expectations despite an extended inflation decline. These inconsistencies contravened essential elements of an IT regime even as some heap praise for its success in India. The contradictions are unlikely to disappear, will persist to pose similar dilemmas in forthcoming times.

RBI was much criticised for overestimating future inflation. As it happened, the central bank nearly halved its predicted inflation for H2: FY2019 to 2.7-3.2% this December from 4.5-4.6% at start of the year and 4.8% just four months ago (August). Unpredictable food price movements underpinned most of these downward revisions. It dragged down headline inflation, especially in past few months when the fall in food prices deepened to turn into deflation. It also offset robust additions to the headline from a 26% jump in crude oil prices over February-October and an equally sharp downswing thereafter. And it countered the steady, simultaneous strengthening of core inflation. Food deflation shaved off 1.02 points from the headline in November alone and an average 11 basis points each month from July.

Much criticism was directed at RBI for these misses, its regular overestimation. But who can really predict food prices with any degree of accuracy? Recall the speculation on RBI’s April’s forecast (4.7-5.1%) for the year’s second half—many considered it rather modest. Who anticipated that robust MSP increases would fail to uplift food prices? Or that market prices would fall below official support prices? RBI is as surprised at the food price collapse, uncertain what this portends for the medium-term food inflation outlook and looking to acquire better understanding of the drivers as the last MPC minutes elaborate.

The fundamental point here is an inherent incompatibility between projecting headline inflation, almost half of which is composed of food prices—an unpredictable component, and which does not figure in the inflation model. Hits and misses arising from food price movements will continue to affect the headline inflation therefore. Not much can be done about this. And all those critics finding faults with RBI researchers should be bold enough to put out their own food price inflation forecasts for next 12 months for public scrutiny!

Next, rising core inflation troubled RBI as much or perhaps even more because it complicated monetary policy decisions. The latter are anchored upon headline inflation, which was affected by its capricious food component. Softer headline inflation outturns conflicted with rising core inflation (minus food, fuels) that hovered in the 6% region for the most part until November. Core inflation concerns underpinned the two-shot monetary tightening of 25bps in June and August 2018 with an appeal to upside risks from oil prices, depreciating rupee, MSP increases, fiscal slippages and external forces even when the central bank over-achieved the mid-point inflation target by August (3.69%). This remarkable misalignment in headline and core inflation is a fundamental discrepancy that will incline interest rate decisions towards core’s evolution even as it violates a basic tenet of the seamless IT framework. And it’s here to stay.

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Third, the link with inflation expectations upon which inflation targeting is founded. It is the anchoring of inflationary expectations upon an explicit inflation target with a credible central bank that conditions behaviour of households and businesses to overlook temporary shocks that, in turn, prevents renegotiation of wage contracts to limit spillovers into a generalized price increase. But median, one-year ahead inflation expectations of households remain unanchored, much above the announced inflation target (4±2%) despite the unrelenting fall in food prices!

How to interpret this? RBI’s analysis preceding introduction of the IT framework clearly spelt out the expectations formation process—high food prices leading to wage-increase demands, which pushed up core prices that fed into higher overall inflation. But, as we see, each link in this chain is disparate, a puzzle. MPC members have underlined high inflation expectations to support continued vigilance and ‘calibrated tightening’; one member (Ravindra Dholakia) suggests measurement problems in these data. The fact remains that achieving inflation targets amidst stagnant, high inflation expectations of 9.8% a year ahead don’t merit adjudication of IT as a success. Many who batted in favour of IT earlier are now ignoring this disparity.

To sum up, three practical and theoretical issues challenge the new monetary policy framework. One, the risks to monetary policy decisions based upon headline inflation affected by unanticipated, unpredictable behaviour of food prices. Two, the mistake in not targeting core inflation that is now causing discomfort in setting interest rates. While the former (headline inflation target) pushes the central bank to become data-driven and less reliant upon one-year ahead inflation projections (which is what brings about greater certainty about the interest rate path), an inability to either explicitly target core inflation or ignore it altogether exposes RBI to confusion and criticism. Three, inflation expectations in India seem difficult to model or capture. Their contrasting trend vis-a-vis the remarkable inflation declines and food deflation is a mystery.

It has to be said that despite the tall claims to success in inflation targeting, an evaluation from the standpoint of its basic tenets questions such verdicts. Each of the elements is yet dubious and must acquiesce for an enduring settlement of the new monetary policy framework. The challenges that surfaced in 2018 will no doubt persist next year.

The author is a Delhi-based economist

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