You are using an older browser version. Please use a supported version for the best MSN experience.

RBI needs to get its inflation forecasts right

LiveMint logoLiveMint 06-06-2017 Aparna Iyer

The Reserve Bank of India’s (RBI’s) inflation marksmanship has had more misses than hits over the years. And it appears that this time too, the central bank is in danger of getting its forecast wrong.

Headline retail inflation in March undershot RBI’s forecast of 5% by a massive 111 percentage points to come in at 3.89%.

In its own monetary policy report in April, the central bank showed its chequered record by highlighting the gap between the forecast on inflation and the actual inflation path. In October 2016, the RBI glide path on inflation showed that retail prices would rise gradually for inflation to be around 5.3% by March 2017. Inflation fell sharply to 3.89% in that month.

It is true that demonetisation amplified the fall in retail inflation. However, the effect of the cash purge on prices is unlikely to have persisted for more than six months given the central bank’s own argument of rapid remonetisation. But the headline inflation print in April was the lowest on record at 2.99%. Clearly, demonetisation alone is not driving prices lower.

Even when the headline inflation print came in sub-4% for five consecutive months, RBI forecast that inflation would average around 4.5% in the first half of 2017-18 and then rise to an average of 5% in the second half. We now know, and so does RBI, that in April inflation was even lower.

Forecasts matter because they give a glimpse into how the central bank wants to progress on the path towards achieving the formal 4% inflation target. So where is RBI going wrong?

In the past, when it went wrong on inflation forecasts during the high inflation period of 2009-2013, the reason was that the central bank underestimated the impact of inflation expectations. By the time it made enough noises about expectations getting entrenched, they had also gotten firmly planted in the economy.

A once bitten RBI is now more than twice shy to loosen monetary policy. Perhaps this time, the central bank does not want to underestimate inflation expectations.

But that would mean that expectations feed into inflation faster only on the upside but not on the downside. Inflation expectations have been easing and so has been inflation for more than four quarters now.

HSBC’s Pranjul Bhandari makes a convincing argument in a report that both forward and backward expectations have fallen, and that would keep inflation low in the coming years.

Getting inflation expectations right is no easy task but RBI needs to let go of its past experience and perhaps lower its inflation forecast.

More From LiveMint

image beaconimage beaconimage beacon