'Food
deflation, crude oil prices and rupee has led to sharp downward revision in
inflation forecast making MPC members scratch their heads to substantiate their
policy decision'
Is forecasting
easy?? Ask a statistician or an econometrician and he will use a number of
variables to arrive at a certain specific two-decimal value of an indicator or
to be on the safer side give a wide range of predicted values. Forecasting is
certainly not an easy task especially in a volatile external environment as
experienced in the global economy in recent times.
The recently
released minutes of the Reserve Bank of India (RBI) shows that members of the
Monetary Policy Committee (MPC) are finding it difficult to make inflation
forecasts in such a volatile domestic and external environment. Drastic and
sudden changes in three key indicators driving inflation namely food inflation,
crude oil and the value of rupee against the US dollar has led to a downward
revision of the inflation forecast for the second half of FY19 by around 120
bps (100 bps is equal to 1%). The upper limit of the inflation forecast for the
second half of FY19 at 3.2% stands 80 bps lower than RBI’s medium term target
for CPI of 4%. The recent period of unpredictability has unequivocally made it onerous
for the MPC members to forecast inflation. How these indicators have changed in
recent times needs to be put under the lens. In addition, going forward, the
risks on account of uncertainty and surprise element remains, making it even
more challenging for the MPC members to make inflation forecasts and anchor
inflation expectations.
Food inflation
First, one
needs to look at the unexpected large collapse in food inflation. Food
inflation has witnessed a sustained decline since May, contracting by -0.1% in
October and subsequently by -1.7% in November (not part of December MPC
analysis). These have primarily been on account of prices of vegetables, pulses
and sugar going into the negative territory. Vegetable prices have seen a
contraction in the last 4 months while sugar prices have seen a contraction
since February. The biggest and
sustained collapse in prices have been seen in case of pulses having witnessed
on an average a double digit contraction in prices of around 15% since
December, 2016. Jawahralal Nehru University (JNU) professor Himanshu, in
his recent column in Mint has highlighted a combination of factors like unnecessary
imports, market restrictions, oversupply of some commodities and an overall
demand deflation, particularly in the rural economy as factors contributing to
food deflation. Although decline in food prices and in-turn low inflation
numbers bodes well from the consumer angle but is remains an implicit
punishment for the farming community. The increase in Minimum Support Prices
(MSPs) announced by the government in July on 17 notified kharif crops by
around 25% (on an average) have not translated into higher prices. This was an
important upside risks considered by the MPC members in the previous two
meetings, which now seems to have mitigated. However, the members have
highlighted that there could be a reversal in this food deflation in the coming
months which needs to be closely monitored. Though the MPC does not look at the
Wholesale Price Inflation (WPI) as an inflation-target, it is also important to
note here that the WPI for food prices has seen a contraction during the last 5
months.
Oil prices and Rupee
The movement
in oil prices and rupee has been looked at in conjunction as moderation in
international oil prices improves the external sector prospects for the country
engendering the currency to strengthen appreciably. The fall in oil prices and
a stronger rupee is a positive from the inflation angle. On the other hand an
increase in crude oil prices and depreciating rupee poses a double whammy
threat for inflation, especially fuel inflation.
The point to
note is the unpredictable developments witnessed in the international oil
market which have kept the oil prices volatile. With domestic prices of petrol
and diesel changing on a daily basis, an increase in the international crude
oil prices instantly translates into higher domestic prices and in-turn higher
inflation. For the first 4 months of the
current fiscal, the oil prices witnessed a gradual increase from $65 per barrel
in the start of the year to $73 per barrel by end July, after scaling a peak of
$76 per barrel during mid-May. This increase in oil prices was considered as an
important upside risk while forecasting inflation by the MPC during the initial
3 meetings of the fiscal. The volatility in oil prices have been noticed since
the 3rd MPC meeting held in first week of August. Between the 3rd (Aug) and the 4th
(Oct) MPC meet, international crude prices rose by around 15% and between the 4th
(Oct) and 5th (Dec) MPC meet have crashed by around 30%. The
rise in oil prices in the month of September-October can be attributed chiefly
to the possible sanctions which were to be imposed by the US government on one
of the key oil producers, Iran. The temporary relaxation granted by the US
President on the sanctions to a set of 8 countries coupled with rise in US oil
stockpiles and expectations of a temporary global demand slowdown (due to
global trade wars and geo-political concerns) has led to a reversal in prices
in a span of 45 days (Nov-Dec). Going ahead, upside risks like decision of OPEC
and Non-OPEC members to cut production levels for next six months and easing
global trade wars could pressurize oil prices while rising US stockpiles and
overall slowdown in global demand could off-set the upside risks, continuing
with the uncertainty and volatility. Basically, one still remains clueless
about the oil price movement.
The volatility
in the oil markets, global trade wars leading to higher safe-haven demand, a
hawkish stance by the US Fed leading to increasing interest rates 4 times in
2018, domestic factors like widening current account deficit and other
geo-political tensions like the Turkish crisis have been factors depreciating
the Rupee taking it to an all-time low of 74.33/$ in October. The Rupee
depreciated by almost 14% between April to October. This depreciation has seen
a reversal by almost 5% in November with the Rupee strengthening on the back of
waiver granted by US on Iran sanctions, softening crude oil prices and higher foreign portfolio inflows.
Despite the unpredictable
reversal (moderation) in the above components in recent months, the members of
the MPC highlighted the upside risks to inflation like high core inflation (inflation
without taking food prices and fuel prices into account) at around 6%, effect
of 7th Pay commission implementations, government fiscal slippages and
sudden reversal in food prices in order to keep the interest rates unchanged
and adopt calibrated tightening as its policy stance. The volatility seen
during this fiscal is likely to continue atleast till the end of FY19. This keeps all analysts and economists at the
edge of their seats while chalking out their predictions while this ambivalence
turns out to be a nightmare for any forecaster, including the model based MPC!!
Sushant Hede
23rd December 2018
Data Source:
1. Centre for Monitoring Indian Economy
References
1. Minutes of the MPC Meeting (Dec 3-5)
2. The political economy of the persistent agrarian crisis by JNU Professor Himanshu
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