A worker carries a basin of limes on his head at a wholesale fruit market in Moazzam Jahi Market in Hyderabad, India (Photographer: Dhiraj Singh/Bloomberg)

Does The RBI Overestimate Inflation?

The Reserve Bank of India's (RBI) consumer price inflation forecasts have been off the mark many times in the past, with actual inflation falling well below what the central bank had originally projected, point out two recent research reports while arguing that there may be room for the central bank to soften its stance.

The reports come against the backdrop of an ongoing debate on whether the central bank has chosen to tighten its monetary policy stance too soon. In February, the RBI changed its policy stance from ‘accommodative to ‘neutral’ citing upside risks to inflation and the need to anchor inflation at close to the central bank’s 4 percent medium term inflation target. Since the shift in stance, reported retail inflation has continued to slip. In April, consumer price inflation fell to 2.99 percent, with core inflation also slipping.

According to Soumya Kanti Ghosh, chief economist at State Bank of India, retail inflation in fiscal 2018 may be below the RBI’s estimates which suggest that inflation will average 4-4.5 percent in the first half of the year and rise to 4.5-5 percent in the second half of the year.

“Inflation fears are now largely a thing of the past,” Ghosh wrote in a report earlier this week. He expects inflation to average between 4-4.5 percent in fiscal 2018. “There could be some inflation numbers that could be closer to 2 percent in the interregnum, and definitely below 2.5 percent.”

Data compiled by Ghosh shows that actual retail inflation has often fallen below the RBI’s initial forecasts and has been closer to the revised forecast put out by the central bank over the course of the year.

Does The RBI Overestimate Inflation?

If inflation projection is kept higher, it may prevent inflation expectations from declining even when actual inflation is falling. This may keep the rates elevated for a longer period of time, the report argued.

At the most recent monetary policy committee meeting in April, the RBI held the repo rate steady but raised its reverse repo rate by 25 basis points. Many saw that as a stealth interest rate hike. Minutes of the committee meeting showed that most members expressed concerns around upside risks to inflation, with RBI executive director Michael Patra even suggesting that a rate hike may need to be contemplated to meet the 4 percent inflation target. Governor Urijit Patel also warned that though headline inflation may have undershot the 5 percent target for March end, the outlook for inflation called for "close vigilance".

We are keen to see how the RBI responds to the recent plunge in CPI inflation, Kotak Economic Research said in its report released on Wednesday. The report called for a softening of the policy stance as early as June. It explained that the high divergence between the RBI’s estimates and actual inflation could be a negative.

We note that RBI has missed its inflation estimates consistently over the past few years. Over the longer term, a significant deviation between estimates and actual outturn could risk a negative effect on expectation settings in an inflation-targeting framework.
Kotak Economic Research Report

The report added that it would expect RBI to review its communication in the June policy review to acknowledge the "significant downward bias" to its estimates. Kotak, however, does not see the RBI cut interest rates and expects rates to stay on hold. Most economists share that view. Bank of America-Merrill Lynch is an exception and expects the central bank to cut policy rates by 25 basis points in August, if India sees a normal monsoon this year.