Home / Opinion / Why RBI didn’t cut the policy rate

The six members of the monetary policy committee have surprised the financial markets by deciding to keep interest rates unchanged in the new monetary policy announced on Wednesday.

Inflation continues to retreat, so what could have made the Reserve Bank of India choose such caution? After all, data released by the Indian central bank soon after the policy was announced shows that the median inflation expectations of households in December have dropped sharply compared to their level reported during the previous quarterly survey.

The answer probably lies elsewhere.

The professional forecasters polled by the central bank have cut their inflation forecast for the third and fourth quarters of the current fiscal year by 0.4 percentage points and 0.2 percentage points respectively. This could be a result of the decline in demand because of the ongoing shortage of cash in the Indian economy.

The Indian central bank thus seems to be on course to meet its informal inflation target of 5% for January 2017, according to its glide path. The statement released by the MPC also says that the inflation target is 5% for the fourth quarter of the current fiscal year.

The going may get slightly difficult from there.

The formal inflation target that the RBI has to now meet over the medium term, starting from the next fiscal year is 4%, though with a band of 2% on either side. The professional forecasters are less sanguine about inflation after April 2017. They have actually increased their inflation forecast for the second quarter of fiscal 2018 by a sharp 0.4 percentage points.

The chart here compares the inflation target for a particular quarter with where the professional forecasters RBI tracks expect inflation to be. This may offer some clues why RBI chose to pause when just about everybody was goading it to cut.

The upshot: The gap between the forecasted inflation and the inflation target is expected to widen a lot in the coming quarters.

Why should inflation forecasts matter?

Even central banks that have inflation as their formal nominal anchor sometimes need what is called an intermediate target to plan their monetary policy actions.

In the minutes of the first monetary policy committee meeting in October, RBI executive director Michael Patra suggested in his published comments that the Indian central bank looks at inflation forecasts as an intermediate target: “In a framework in which inflation forecasts congeal all available information and serve as the intermediate target of monetary policy, two aspects are noteworthy: (a) the level of the inflation forecast for Q4 of 2016-17 is closer to the target than before; and (b) it has been moving down in relation to the second and third bi-monthly statement projections."

RBI has its own inflation forecasts, but they currently do not go beyond the end of the current fiscal year. The inflation uptick expected by private sector economists in the next fiscal year could be a worry at a time when headline inflation has to be brought down by a full percentage point.

Does the widening gap between private sector inflation forecasts and the inflation target of the central bank explain the decision taken on Wednesday to pause rather than cut?

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