India inflation record under a new monetary policy regime

Mumbai: What has been the average inflation rate in India in the 30 months since the government officially notified in June 2016 that policy interest rates would be set by a six-member monetary policy committee (MPC)? The answer is a surprising one. Inflation has averaged 3.9%, just a whisker below the medium-term target that has been set for the MPC by the government.

This number is worth underlining at a time when Shaktikanta Das has taken charge as the new RBI governor. Inflation has collapsed to its lowest level in November, and the MPC is under fire for misreading the inflation tea leaves.

The problem with simple averages is that they hide important nuances in the data. Headline inflation has been volatile in this period, ranging from 6.1% in July 2016 to 1.4% in June 2017.

This volatility is partly explained by developments such as the demonetisation shock, the gyrations in the global energy market, and the secular decline in food inflation since June 2016. Other complications have included the transition to the new goods and services tax (GST) regime and the effect of higher house rent allowances for government employees on the rent component of the consumer price index.

The government has said that the MPC will have failed to do its job in case inflation is outside the permissible band for three consecutive quarters—below 2% or above 6%. That has not yet happened. However, there are less extreme ways of judging the performance of the MPC. It has on average kept headline inflation close to target but has been less effective in terms of core inflation.

The trend in core inflation—calculated after the effects of volatile items such as food and fuel are removed from the headline inflation number—is a bit different. Average core inflation over the past 30 months has been 100 basis points higher than 4%. Expectedly, core inflation has been less volatile than headline inflation.

Some of this is because of the temporary statistical effect of higher house rent allowance, but in general the MPC has been relatively less successful in keeping core inflation closer to the central point of its inflation comfort zone.

The other way to look at the issue is through global comparisons. India began the decade with significantly higher inflation than the rest of the world, as well as Asian peers. Such a global comparison gives us some intuitive sense of domestic policy success since all countries are otherwise subject to the same shocks from oil and food prices.

The inflation gap with other countries has now narrowed, making India less of an inflation outlier than before.

Part of the credit has to go to fiscal policy as well.

The RBI has faced a lot of criticism in recent months for its inflation forecast errors. Why do these matter? What the central bank does today affects the economy around six to nine months down the line, so the MPC should not take decisions based on recent data but the inflation forecast for two or three quarters into the future. An earlier Plain Facts column by Tadit Kundu had shown that RBI has been overestimating inflation, an error that other central banks have also made in recent years. The April 2017 monetary policy report was way off the mark in its inflation forecasts, the October 2017 one did a better job, while the April 2018 also seems to have overestimated inflation.

One defence of the central bank could be that it was blindsided by the gyrations in food and fuel prices, but that does not take into account the fact that the RBI inflation forecast framework explicitly deals with core food and fuel price trends though separate equations.

So forecasting non-core prices is an important part of the overall model. Also, there is no standard format for reporting inflation forecasts. For example, the MPC sometimes provides inflation forecasts for a specific month, sometimes for different quarters, sometimes for half a fiscal year.

This lack of standardization makes analysis difficult, unlike the Dot Plots given by the US Federal Open Market Committee.

Indian macro policy—fiscal as well as monetary—has not done a bad job in bringing domestic inflation closer to global levels. Headline inflation has been maintained near 4%. The acid test will be passed when inflation expectations get anchored near the inflation target, so that temporary shocks to prices do not need hasty interest rate responses.

Niranjan Rajadhyaksha is research director and senior fellow at the Mumbai-based IDFC Institute.