Puzzling inflation projection and dovish tone

The risks to inflation are higher than they have been for a while. These risks primarily originate in the macro-economy. Growth has picked up (GDP for 2-18-19 projected at 7.4 per cent), domestic demand is strengthening, there is risk of fiscal slippage - both Union and States, elevated oil prices continue with uncertain outlook, the revised formula for minimum support price could bring in pressure on the fisc or on food prices and there could be a second round impact of HRA increase. There are also risks to inflation in the event of pressure on the rupee in the context of slowing capital flows and a worsening current account deficit. There seems to be some comfort on the food front but this depends on a good monsoon. In this context, it is surprising how the projection for inflation has been reduced, imparting a dovish tone to the monetary policy statement. Both stock and bond markets have reacted positively and bank stocks have soared.

There are two sentences in the resolution that give some clue for the lower projection: “With the sharp moderation in food prices in February-March, the inflation trajectory in H1: 2018-19 is expected to be lower than the projection in the February statement, despite a likely reversal in food prices in H1. Overall food inflation should remain under check on the assumption of a normal monsoon and effective supply management by the Government. …Fourth, the statistical impact of an increase in HRA for central government employees under the 7th CPC will continue till mid-2018, and gradually dissipate thereafter.”

Getting the inflation projection even nearly right is tough, especially when a huge component is food and fuel. Hence RBI has to necessarily act on the basis of the drivers of inflation. A reading of the more detailed monetary policy report accompanying the resolution does not throw much more light. If at all, it seems to suggest that inflationary pressures may intensify. “Turning to the outlook, inflation expectations of urban households remain elevated, according to the March 2018 round of the Reserve Bank’s survey. Inflation expectations three months ahead and a year ahead increased by 30 bps and 10 bps, respectively, from the previous round (December) to 7.8 per cent and 8.6 per cent, respectively. Manufacturing firms polled in the Reserve Bank’s industrial outlook survey (March 2018) expected higher input price pressures in Q1: 2018-19 due to rising cost of raw materials (higher negative values for cost of raw materials indicate higher input price pressures). Selling prices are also expected to increase, but not sufficient to protect profit margins. The Nikkei’s purchasing managers’ survey also indicates both input and output price pressures for manufacturing (March 2018) as well as services (February 2018) sectors.

Professional forecasters surveyed by the Reserve Bank in March 2018 expect CPI inflation to firm up to 5.1 per cent in Q1: 2018-19 and moderate thereafter to 4.3 per cent in Q4: 2018-19 (Chart I.5). Their medium term inflation expectations (5 years ahead) remained unchanged at 4.5 per cent, while longer-term inflation expectations (10 years ahead) increased by 40 bps to 4.5 per cent. Taking into account the initial conditions, signals from the forward looking surveys and estimates from structural and other models, CPI inflation is projected to pick up from 4.4 per cent in February 2018 to 5.1 per cent in Q1: 2018-19 due to unfavourable base effects and then moderate to 4.7 per cent in Q2, and 4.4 per cent in Q3 and Q4, with risks tilted to the upside. For 2019-20, assuming a normal monsoon and no major exogenous/policy shocks, structural model estimates indicate that inflation will move in a range of 4.5-4.6 per cent.”

The only forecast that is close to the RBI projection for inflation is that of the professional forecasters. When the macro-economic parameters such as fiscal deficit, aggregate demand, current account deficit and narrowing of output gap would suggest a change in stance, or at least the adoption of a more hawkish tone, perhaps the MPC did not want to dampen the growth momentum.

Perhaps there are other considerations that are more to do with financial stability. There have been concerns that the banking system has been hit on several fronts at the same time. MTM losses on the bond portfolio due to rising global bond yields and concerns of fiscal slippage, total withdrawal of all restructuring schemes requiring earlier disclosure of NPAs, and spate of frauds being uncovered. There have been a number of recent measures to soften the blow- a lower market borrowing program with higher share of floaters and shorter-term bonds, permission to spread the bond MTM provisions over the entire year and deferment of implementation of Indian Accounting Standards (Ind AS) by one year. Today’s policy certainly made the bankers smile!

It brought to mind Deputy Governor Acharya’s remark “It is best for sake of policy credibility to not mix instruments with objectives they are not meant to target.”

(The writer is a former deputy governor of the Reserve Bank of India)