Inflation forecasts lie at the heart of any central bank’s monetary policy decision-making. In India, the Reserve Bank of India (RBI) adopted the flexible inflation target (FIT) framework in June 2016 and a predetermined 4% inflation rate which made inflation forecasts critical in helping it decide whether to cut or hike rates. In recent years though, the RBI has regularly overestimated the threat of inflation, according to a new study conducted by Janak Raj and others of the RBI.
In the study, the authors compare inflation forecast data with actual inflation between April 2015 and December 2018. They find two episodes when actual inflation deviated from forecasts and both these deviations coincided with unexpected fall in food prices. Between October 2016 to March 2017, vegetable prices plunged in the aftermath of demonetization while prices of pulse fell due to over-production. The second episode of deviation between June to September 2018 saw stagnation in vegetable prices due to excessive supply.
Changes in food prices can swing inflation significantly because of food’s importance in India’s Consumer Price Index (CPI), which the authors believe hinders accurate inflation forecasts.
The RBI overestimating inflation is part of a global trend since the 2008 financial crisis. A cross country comparison of inflation forecast errors shows that India’s forecast errors are mostly in line with other countries. Like in India, across the world, forecast errors are associated with the share of food in the country’s CPI. Given this, the authors argue that the RBI’s forecasts are unbiased and efficient and compare favourably with other central banks.
Also read: Inflation Forecasts: Recent Experience in India and a Cross-country Assessment
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