The monetary policy committee (MPC) surprised the financial markets once again in October. Five of its six members voted to leave policy interest rates at current levels even though it switched its stance from neutral to calibrated tightening. Only Chetan Ghate voted for a rate hike while Ravindra Dholakia voted to stick to the neutral stance. Most polls of the private sector economists had shown an overwhelming expectation that interest rates would be raised for the third time in a row. The MPC majority thought otherwise.

There is a deeper puzzle here. The Indian central bank as well as the economists it surveys expect consumer price inflation to come down in the months ahead, before rising once more. This is perhaps the first time in recent memory when Indian inflation is expected to be muted despite higher global oil prices, a weaker rupee and a poor monsoon. They are usually the catalysts for accelerating inflation. The Reserve Bank of India (RBI) inflation forecast model broadly estimates that a 10% increase in oil prices pushes up inflation by 20 basis points. There are two forces at play. Higher oil prices feed into input costs across the economy while they also have a smaller disinflationary impact because of lower aggregate demand.

The baseline assumptions used by the RBI have changed since April. The Indian crude oil basket is now assumed to be at $80 a barrel rather than $68. The exchange rate used in the forecast model is 72.5 to a dollar rather than 65.5. The monsoon is 9% below the long period average compared to the April assumption of a normal monsoon. This is a combination of factors that should usually send inflation shooting up. What is happening?

Economists have been divided on this key question. The latest edition of the World Economic Outlook released by the International Monetary Fund provides a useful overview. One group believes that inflation in emerging markets such as India is very sensitive to exogenous shocks such as global oil prices. The flip side of this structuralist argument is that inflation in most emerging markets came down in recent years because of global factors such as muted oil prices or the deflationary impact of the Chinese export boom. The MPC in its October statement has also said that unexpected benign food inflation has offset the broad uptick in fuel, transport, personal care, education and healthcare prices.

The alternative explanation focusses not on factors beyond the control of the central bank but the direct consequences of its actions. A credible central bank that has anchored inflation expectations gives citizens the confidence to look past temporary shocks in terms of higher fuel prices or food prices. This is the central claim of inflation targeting. The jury is still out whether inflation expectations have indeed stabilized in India, even going by the latest households inflation expectations survey conducted in September, but there is little doubt that the credibility of macro policy is now higher than what it was five years ago.

This column had noted in October 2014: “There is growing confidence that the Indian government will be well placed to meet its budgeted fiscal deficit target while the Indian central bank seems to be on track to meet its immediate inflation target for January 2015. This comes in the wake of a long period of successive governments rarely meeting their fiscal deficit targets while inflation drifted outside what the Indian central bank considered its zone of comfort. Such an inability to meet policy goals has damaged the credibility of Indian economic policy. The recent hopes that policy targets will be met this year should be seen as only the first step in a long journey towards making policy more credible."

A recent paper by written by MPC member Dholakia in collaboration with Virinchi S. Kadiyala of ICICI Bank (Changing Dynamics Of Inflation In India, Economic And Political Weekly, 3 March 2018) offers some tantalising insights into the Indian inflation puzzle. The two economists have highlighted two profound changes in domestic inflation dynamics. First, inflation persistence has come down as shocks to core inflation dissipate rather than lead to higher headline inflation. Second, headline inflation reverts to core inflation because of anchored inflation expectations. This is in contrast to the historical experience when core inflation moved towards the headline number after sudden shifts in food and fuel prices. In other words, it is likely that the credibility of Indian macro policy, and monetary policy in particular, has been rebuilt. Citizens no longer change their inflation expectations with every price shock. They believe the central bank will stabilise inflation near the promised level.

The recent stability of Indian inflation despite the oil, exchange rate and monsoon shocks could either be explained by the structural shift in food supplies or the initial success of the flexible inflation target regime in anchoring inflation expectations. A clearer answer will matter a lot as India tries to adjust to the new global combination of quantitative tightening by central banks of developed countries, the flight of risk capital from emerging markets as US interest rates increase, the prospect of higher inflation in many large economies and the disruptions to the international economic system because of trade wars.

Flexible inflation targeting was introduced in India at a time when the global commodity cycle was in a downturn. Its initial success is undoubtedly welcome. The acid test lies ahead—keeping inflation expectations anchored despite the potential risk from multiple disruptions.

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute.

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