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    Why Reserve Bank of India should fix inflation forecasting model now

    Synopsis

    Whichever index the central bank took as benchmark – whether Wholesale or Consumer Price Index, its forecast was off the mark in the past five years.

    ET Bureau
    When Chief Economic Adviser Arvind Subramanian expressed his angst at the Monetary Policy Committee for not reducing interest rates at its June meeting, he didn’t stop at criticising the stance, but questioned the very fundamentals on which the panel rested its decision – the Reserve Bank of India’s inflation forecasting model.

    Inflation readings in the past few months have been far lower than the central bank’s expectations. Whichever index the central bank took as benchmark – whether Wholesale or Consumer Price Index, its forecast was off the mark in the past five years.

    RBI had in its October policy projected CPI inflation at 5%, but the inflation ended up at 3.81%. The year before, it was projected to be at 4%, but closed at 3.7%. In fiscal 2015, the actual inflation was 5.6% in January 2016 compared with a forecast of 6%.

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    “There is more an element of caution in RBI forecasts and that could lead to unsatisfactory results if the going is good,” says Abheek Barua, economist at HDFC Bank. “It is naive to think that all monetary policy decisions are based entirely and mechanically on a statistical model. There is discretion and judgment involved. In executing its mandate, the RBI is erring on the side of caution.”

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    INFLATION TARGETING
    The RBI’s forecast of prices is more important now than ever as the country has adopted inflation targeting as a policy. This calls for the six-member MPC headed by the RBI Governor to ensure inflation as measured by the Consumer Price Index is maintained at 4%, with a provision to move in a two percentage point band on either side.

    The shift to targeting was warranted after years of poor monetary policy decisions without a clear objective led to distortions in the economy like savings moving to real assets such as gold and property, and corporates bingeing on debt. But high interest rates due to poor inflation forecasting can distort as well. Financial savings can turn higher than warranted, and businesses would hold back on investments, restricting economic expansion.

    Historically, Indian inflation was driven mostly by food and crude oil prices since the country imports more than twothirds of its needs.

    In the past 18 months both these factors have undergone changes, which may require adjustments in forecasting. While expectations of oil price rebound have been misplaced, food prices have moderated not only because of increased output, but the structural change in the way it reaches markets. The wage-price spiral induced by the National Rural Employment Guarantee Scheme is absent and the excess capacity created during the gogo years of credit is also keeping prices in check.

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    “There is sufficient slack in the economy and in the labour market, which along with a benign outlook for global commodity prices should keep India’s headline inflation below 4%,” says Jahangir Aziz, economist at JPMorgan. “We believe that the excess capacity in Indian industry and labour market is perhaps larger than what the RBI considers to be the case.”

    DHOLAKIA’S DISCORD
    These developments have not missed the attention of the MPC. The RBI has brought down its forecast of inflation for the first half and the second half of the current fiscal year.

    It has cut its forecast of CPIheadline inflation downward to 2 to 3.5% during the first half from 4.5%; and 3.5 to 4.5% in the second half from 5%. In the first quarter, it averaged 2.14% with the June reading reaching a record low of 1.54%, breaking the lower bound of 2%.

    Ravindra Dholakia, a member of the MPC, questioned the central bank’s forecasting methodology when he raised the conclusions about the fallout of the implementation of house rent allowance by state and Union governments.

    “The impact assessment on the headline CPI inflation of about 150 basis points by the RBI is highly overstated because it assumes simultaneous and instantaneous implementation by states and the Union governments,” Dholakia was quoted as saying in the June meeting minutes. A basis point is 0.01 percentage point.

    TAYLOR RULE AND ACHARYA’S GOOGLY
    What is at the heart of inflation targeting is the so-called Taylor Rule named after economist John Taylor. It is a model that gives policy rate prescriptions after taking into account the difference between targeted and actual inflation and potential and actual output growth.

    RBI’s revised inflation forecast shows that the average for the year could be 3.5% and that opens up a huge window for policy rate reduction. Furthermore, the growth of 6.1% in the March quarter and the forecast of 7.4% opens up room for sharp rate cuts with potential growth rate at 8%.

    But the RBI has shifted the goal post when it comes to the desired rate of real interest rate, i.e., nominal interest rate adjusted for inflation. From about 1.25 to 1.75% in the past, it now wants higher rates for a reason other than inflation.

    “Tolerance for a slightly higher real rate of interest is justified to ensure weak banks do not find relatively low the hurdle rate for ever-greening (perennial extension) of bad loans,” deputy governor Viral Acharya said justifying his vote for status quo in June. “What is required for monetary policy to do its job better is to address the stress on bank (and highly-indebted borrower) balance sheets.” Even if one assumes that the RBI is now comfortable at as high as 3% real rate, there is still room to reduce rate by at least 50 basis points going by the Taylor Rule as there is slack in the economy. That inflation broke the lower end of the band should give comfort to the MPC to go for a cut beyond the customary 25 basis points.

    “With inflation consistently surprising on the downside in the past few months and June/July slipping below the lower end of the targeted 2-6% band, the window for a rate cut does exist,” says Radhika Rao, economist at DBS Bank.

    CREDIBILITY IN QUESTION
    Investors in general have cheered the conservatism of the RBI in the past four years. But the pendulum appears to have swung from an extreme of ignoring the evil effects of inflation to promote growth, to seeing inflation everywhere even where none exists. Troubles of banking industry has joined inflation in determining interest rates.

    Central banks in developed nations too face the problem when it comes to forecasting inflation. The US and Europe have been missing the targets on inflation, but their forecasts have been closer than what it is in India.

    “No forecasting model can be 100% correct,” says Saugata Bhattacharya, economist at Axis Bank. “The focus now should be on improving price surveys and models to better understand the price formation process.”

    But for an emerging economy such as India, inflation undershooting the target can be as harmful as overshooting in terms of damage to the economy. It may be time to fix the inflation forecasting model which even a member of the MPC has criticised before more damage is done.

    “This could lead to serious loss of credibility if not coursecorrected early,” says JPMorgan’s Aziz.


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