Inflation forecasting: With RBI getting it wrong, cutting repo rate is just the first step – The Financial Express–17.07.2017

  • It is not clear whether CPI inflation at a historic low of 1.5% in June—the last time we saw such low inflation was in 1999 and before that in August 1978—and well below RBI’s lower bound of 2% will convince the central bank to cut repo rates next month.
  • But more than that, RBI needs to do some serious introspection over its inflation forecasting methodology.
  • The chief economic advisor doing an I-told-you-so when the data came out may not look graceful, but he has a point when he talks of a ‘paradigm shift in the inflationary process’ and of ‘large, one-sided and systematic inflation forecast errors’.
  • In October 2016, RBI projected March 2017 inflation at 5.3%, by December this was lowered to 5% and in February 2017, it was lowered to under-5%—with the actual at 3.9%, this meant RBI got it wrong by 110 bps for a forecast being made for just one month down the line. The forecast for June, made in April, was 4.2% whereas the actual has come in at 1.5%, suggesting the element of error is rising. Not surprisingly, while RBI had forecast 4.5% CPI-inflation in H1FY18 and 5% in H2, it slashed these by 175 bps for H1 and 100 bps for H2 in its June outlook.
  • What is amazing is that, despite all evidence that inflation is in a new zone, RBI continues to want to ‘remain watchful of incoming data’.
  • Certainly, with inflation starting to fall off from August 2016, the base effect will mean inflation over the next few months will be higher than it would have been normally – will RBI then use that as a reason for not cutting rates?
  • Keep in mind, RBI’s own CPI forecast for the year averages below 4%, suggesting it should be cutting rates since the economy is in deep trouble and there is little sign that inflation will spiral out of control.
  • So far, the monsoon has been good and sowing (till July 14) was 8% above last year—24% in the case of pulses. The global outlook for crude oil has worsened and even lower prices are being forecast. With May IIP once again collapsing, to 1.7%—this is the fifth month of negative growth in consumer durables—it is obvious the output gap continues to rise, ensuring little or no pricing power in the manufacturing sector.
  • Indeed, with manufacturing first being disrupted by demonetisation and then by GST, the supply chain will take some months to recover—so, it is likely the output gap will continue to remain large and inflationary pressures limited.
  • RBI is right when it argues it will take more than interest rates to revive investment since there is the twin balance-sheet problem as well as large infrastructure bottlenecks. But arguing interest rates are not the only factor that determine investment is not the same as arguing they don’t matter at all. After all, if real interest rates are, as they are, at a 20-year high, with no signs of any great revival in demand, this will ensure no one will invest at all and it will also dampen consumption.
  • With the economy in desperate need for a stimulus and interest rates completely out of whack, it is not clear why RBI is refusing to cut repo rates since inflation remains firmly under control.

via Inflation forecasting: With RBI getting it wrong, cutting repo rate is just the first step – The Financial Express

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