India now has an inflation targeting central bank and a monetary policy committee. The first three monetary policy committee meetings have taken place. The first meeting cut the de jure policy rate, and the next two meetings chose to hold.
Winston Churchill once said If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions. However, all the three meetings of the MPC featured six economists with one opinion.
In this article, we argue that conditions in the economy suggest that it is time to worry about forecasted inflation going closer to the low end of the target range.
Let’s start at the measure of inflation that is used in defining RBI’s objective, i.e. the year-on-year change of CPI:
|Headline inflation, i.e. year-on-year CPI inflation|
Y-o-y CPI inflation breached 5% in February 2006. After that, we had a long and painful bout of inflation. A recession began in India in 2012, and by mid-2013, inflation was on the decline. The latest value, for January 2017, shows 3.17%. This is benign when compared against the range from 2 to 6 per cent, which is coded into the RBI Act.
Each reading of year-on-year inflation is the average of twelve changes for the latest twelve months. To understand what is going on in the economy in recent days, it’s useful to look at month-on-month changes. This requires seasonal adjustment. We have developed the models for seasonal adjustment at NIPFP, and will use this ahead.
Roughly half the CPI basket is food and food inflation is thus critical for the overall CPI. What is going on with food inflation? We use the WPI Food to look at this:
|Month-on-month WPI Food inflation (SA, Annualised)|
The values above are annualised month-on-month changes of seasonally adjusted WPI Food. This shows that from July onwards, we have had remarkably low food inflation. The CPI inflation that we have got stems from non-food inflation. Looking forward, the outlook for non-food inflation is limited because of softness in global prices of tradeables.
The poor man’s statistical model of y-o-y CPI inflation is to forecast the m-o-m values using univariate time-series methods, and add up the latest 11 facts with 1 forecast to get a one-month ahead forecast. When we do this, the forecasts for February, March and April work out to 3.32%, 3.65% and 3.43%. These benign forecasts use no economic knowledge – they only reflect the time series structure of month-on-month inflation. These should be treated as the baseline on top of which we layer on economic thinking.
What about pressures on aggregate demand? There are four perspectives which suggest that the demand side will be weak in 2017 and 2018.
These four problems are, of course, inter-related. We overstate the gloom when we think of them as four orthogonal issues. Each of the four is a difficult problem which resists quick solutions. As an example, consider the time series of cash in circulation:
|Cash in circulation (Trillion rupees)|
If you extrapolate the straight line at the end, it will be many months before cash is back to pre-shock conditions. Similarly, consider the year-on-year changes of imports by the US from China:
|Imports by the US from China|
It is remarkable to see that the recent low value was as bad as that seen in the 2008 crisis. The sluggish values here bode ill for global demand for Indian exports.
These four difficulties suggest that output and inflation will evolve in a more negative way as compared with the baseline statistical forecasts described above. In this case, CPI inflation outcomes could be knocking on the lower end of the target range.
We feel that these issues will weigh on monetary policy in 2017 and 2018. Monetary policy acts with a long lag, so we have to look ahead when thinking about policy changes today. Further, monetary policy in India is relatively ineffectual, as the monetary policy transmission is weak. Mere 25 bps changes have little impact. When monetary policy in India has to move, large moves are required. We feel that substantial reductions of the short rate are required in 2017 in order to stay at the inflation target of 4%.
The authors are researchers at the National Institute for Public Finance and Policy.