Has RBI consistently over-estimated inflation in its forecasts?

Citing upside risks to inflation, the monetary policy committee of the Reserve Bank of India (RBI) decided to keep interest rates unchanged in its meeting last week. But not everyone agrees with RBI’s assessment of India’s inflation trajectory. At least two members of the newly constituted Prime Minister’s Economic Advisory Council (PMEAC)—Surjit Bhalla and Ashima Goyal—have been publicly advocating a rate cut, citing RBI’s poor inflation forecasting record.

A Mint analysis of past inflation forecasts by RBI suggests that it has indeed been overestimating inflation in the past two years. But RBI’s forecast record does not seem to be very poor once we consider volatility in price levels of a few food items that have fluctuated sharply in the past two years.

In its statements since early 2015, RBI consistently expected retail price inflation to rise to 6% by January 2016 from the prevailing levels of around 5%. Actual inflation in January 2016 turned out to be 5.7%. This year, actual inflation in March (3.9% year-on-year) undershot RBI’s forecast of 5% by a wide margin. Subsequently, RBI in its April statement projected inflation at 4.5% for the first half of fiscal 2018 (April-September 2017). But actual inflation averaged only 2.6% over these six months. It is only in recent months, as inflation rebounded from the trough of 1.5% in June, that RBI’s forecasts have matched actual trajectory.

But despite this overshooting record, RBI’s forecasts have been marginally superior to that of the median professional economist in India.

The inflation forecasts by professional economists and RBI often move together, and have often missed actual outcomes.

What about the record of other central banks? Very few have had a shining record in forecasting inflation in the past year, data shows. The inflation forecasts of two inflation-targeting central banks of emerging market economies—South Africa and Brazil—have overshot realized inflation levels by a wide margin this year. Inflation in the advanced world has also tended to lag behind the targets and forecasts of its central banks.

However, the similarities between RBI and other central banks end there. In light of lower-than-expected inflation since 2017, the central banks of both South Africa and Brazil have lowered their inflation forecasts and cut interest rates. RBI hasn’t cut rates. Instead, it has been raising its inflation forecasts despite the past misses.

This had made critics question RBI’s inflation forecasting framework and the rationale for not cutting interest rates further. One reason why the monetary policy committee may have stuck to its guns is the volatile nature of food inflation in India, which most economists expect to rise. In fact, after accounting for fluctuations in the price-levels of a couple of food products, RBI’s record in predicting the inflation trajectory appears remarkably accurate.

Two food items—vegetables and pulses—which constitute roughly 8% of the consumer price inflation (basket) have accounted for much of the volatility in overall price levels over the past two years. As an earlier Plain Facts column pointed out, both weather-related and policy-related disruptions such as demonetization may have contributed to the volatility in prices of these products.

Excluding these two items (and thus accounting for 92% of the CPI basket), the inflation level in the country has been close to RBI’s targets.

Apart from the volatility in food prices, RBI’s own history may be weighing on its decisions today, and may have made it and its monetary policy committee less sensitive to inflation undershoot than to inflation overshoot. After all, RBI was behind the curve on inflation for many years in the post-crisis era, which arguably contributed to India’s macroeconomic instability in 2012-13, and the currency crisis which followed.

The course-correction that followed eventually paved the way for an inflation-targeting regime in India, and led to the creation of the monetary policy committee last year. The nature of the volatility in inflation over the past two years, and the historical record of RBI over the past decade can perhaps help us understand the current cautious stance of RBI.