India’s new monetary policy framework of flexible inflation targeting confronts unique and unanticipated challenges from last year. The mandated target – headline consumer price inflation or CPI at 4% (+/- 2% band) – is consistently being dragged down by sharp undershooting of food inflation. On the surface, it seems the sustained achievement of price stability objective – at 3.5% monthly average, headline inflation remained below target through 2018-2019 – would make monetary policy decisions straightforward. But not quite so – the low headline inflation is deceptive because it masks adverse movements in underlying trends of other key elements of a comprehensive inflation targeting (IT) regime. This article discusses these issues.
Three outstanding features mark monetary policy from 2018: One, unpredictable food prices that are leading to a systematic undershoot of RBI’s inflation forecasts (Fig 1). Two, the sticky, relatively high core inflation (this excludes the volatile food, fuel components from headline inflation) that underpins the RBI’s projected path of inflation. And three, elevated one-year ahead inflation expectations of households despite an extended inflation decline.
These inconsistencies contravene the essential elements of an IT regime, although some praise its success in India. Let us consider each element of a simple IT framework in the context of price developments from 2018:
- The output gap was closing or completely closed, i.e. economy growing at full potential beyond which inflation risks would surface, upto December 2018. In 2019, growth fell below trend and the output gap was assessed as negative in the recent, April 2019 monetary policy review.
- Inflationary expectations rose in 2018 with median, one-year ahead expectations close to 10%. Despite climbing down this year, they hover around 8% – much above the 4% anchor target.
- Core inflation has stayed above 5% or even closer to 6%.
There has been plenty of criticism of the Reserve Bank for overestimating future inflation. For instance, the central bank nearly halved its H2:2018-19 inflation projections in December from that in April 2018. This pattern holds this year too, e.g. headline inflation projections have already been revised down 90-120 basis points (bottom row, Fig 1) as actual outturn in Jan-Feb 2019 undershot RBI’s projected inflation for this March quarter.
Figure 2 illustrates that unanticipated low food prices underpinned most of the downward revisions to headline inflation forecasts. Food inflation pulled down headline inflation, especially in December 2018 quarter when the fall deepened and turned into deflation. Food deflation shaved off 1.02 basis points from the headline in November-December 2018 alone; it subtracted an average 71 points each month in October ‘18-February ‘19! Ultra-low food inflation also countered the robust additions from the 26% jump in crude oil prices last year (this pushed up headline an average 111 points each month in June-Nov 2018). Finally, depressed food prices also masked the stubbornly high core inflation that contributed an average 263 points each month to headline inflation.
The RBI has been severely criticized for its regular overestimation of future inflation. The reality however is that food prices, exposed to volatile supply shocks, are indeed very hard to predict with any degree of accuracy. Food prices have also responded uncharacteristically to familiar impulses in this period, e.g. they failed to uplift despite the hefty hike in farm support prices (MSP) announced by government last year while market prices of most food items sank below the official floor. This unprecedented crumpling of food prices has befuddled everyone including RBI, which is still unclear about the portent for the medium-term outlook for food inflation and trying to understand the drivers of this price collapse better.
The fundamental point here is the inherent incompatibility between projecting headline inflation, nearly half of which is composed of food prices – an unpredictable component and which does not figure in the inflation model. Therefore, hits and misses originating from food price movements will continue to affect headline inflation and upset RBI’s inflation forecasts, thus confusing monetary policy decisions.
Next, rising core inflation has also concerned the RBI as it complicates monetary policy decisions that are based upon headline inflation, which is already affected by the capricious food price component. Softer headline inflation outturns conflict with rising core inflation stuck in the 5-6% region. Core inflation concerns underpinned the two-shot monetary tightening in June and August 2018 (Fig 3) even when the central bank over-achieved the mid-point 4% target with prices, rupee depreciation, MSP increases, fiscal slippage and external factors flagged as upside risks. This misalignment in headline and core inflation is a fundamental discrepancy that tilts interest rate setting towards the latter even as it violates a basic tenet of the seamless IT framework. This discrepancy will persist too.
Last of all is the link with inflation expectations, the foundation of inflation targeting framework. It is the anchoring of inflationary expectations upon an explicit inflation target with a credible central bank that conditions the behaviour of households and businesses towards overlooking of temporary shocks and prevents renegotiation of wage contracts, thus limiting spillovers into a generalized price increase. But as Fig 4 shows, the median, one-year ahead inflation expectations of households remain unanchored, much above the inflation target (4% +/-2) despite the unrelenting fall in food prices!
How to interpret this? The RBI’s analysis preceding introduction of the IT framework clearly spelt out the expectations formation process: high food prices lead to wage-increase demands; rising wages push up prices of the core component of consumers’ price basket, feeding into overall inflation. But as explained above, each link in this chain is disparate, which is a puzzle. The disparity between achieving the headline inflation target amidst elevated inflation expectations cannot be ignored in assessing success of the IT regime.
To sum up, three practical and theoretical issues challenge the new monetary policy framework. One, the risks to monetary policy decisions based upon headline inflation that is impacted by the unpredictable behaviour of food prices. Two, not targeting core inflation is causing discomfort in setting interest rates: the headline inflation target compels the central bank to become data-dependent and less reliant upon one-year ahead inflation projections, while the inability to explicitly target core inflation or ignore it altogether creates confusion and criticism of monetary actions. And three, inflation expectations in India seem difficult to model or capture; their contrasting trend vis-a-vis the remarkable inflation decline and food deflation is a mystery.
In conclusion it has to be said that inflation targeting is not straightforward amidst such price uncertainties as its basic tenets do not align correspondingly. These elements still remain doubtful and must acquiesce for an enduring settling of the new framework. The contradictions also seem unlikely to disappear soon and likely pose similar dilemmas for monetary policy ahead.
By Renu Kohli
Renu Kohli is a New Delhi based economist.