No proof required: MPC — you are not in D-School any more

One logical way for the MPC to change course and lower rates is by being Keynesian at the June 7 meeting — the facts have changed, so we have changed our mind

Written by Surjit S Bhalla | Published: June 6, 2017 12:05 am
C R Sasikumar

The MPC meets on June 6 and 7, their fifth meeting to decide the course of monetary policy and exchange rates. Over its last four meetings, the MPC has flip-flopped on various issues of policy and inference; this meeting is a chance for the MPC to redeem itself.

Consider this. At its first demonetisation meeting on December 7, the MPC concluded that demonetisation was temporary and so, it should look through its effects on dampening inflation and growth. It expected inflation and GDP growth to hustle up in a “V-shaped” pattern. The reality — GDP growth has been flat at 7 per cent, inflation has followed just the first half of the V. The MPC’s post-demonetisation short-term three-month forward forecast for March 2017 was 5 per cent with an upside bias. Actual March 2017 CPI inflation — a low 3.5 per cent! Actual April CPI inflation — 3 per cent. I have searched far and wide but not found any central bank, or even an amateur economist, with such a large forecast error for a three-month projection. These forecast errors are liable to get worse.

May CPI inflation, the data released less than a week after the RBI policy statement on June 7, is on track to register inflation in the range of 2-2.4 per cent. This eis based on daily food price data by the government. If the 2.2 per cent CPI inflation figure does materialise, then CPI inflation in May will be the lowest since June 2001. (Estimate based on a weighted average of the CPIs for industrial and agricultural workers for years prior to 2011).

With (median) developed economy inflation stable to declining, with median emerging market inflation just 150 basis points above developed economies, and nearly the lowest ever, with oil prices stable — it is a bit difficult, if not impossible, to argue that Indian inflation has also not structurally declined to the 3-4 per cent range (and possibly lower). Hence, the MPC should come clean in recognising this change — or argue, with evidence, that Indian inflation will bounce back to 4.5-5 per cent. But evidence, please.

Foreign investors seem to be especially forgiving of the RBI for its past “errors”. But they know better, having critically observed India under Rajan, and other economies. One reason for their “forgiveness” could be because they have a massive conflict-of-interest problem. They actually are the ones who have benefited enormously from MPC miscalculations.

Note the movement of the Indian rupee vis-à-vis the US dollar. Between January 1 and Feb 7, the rupee traded in a narrow band: Rs 68/$ and Rs 67.4/$. On February 8, the MPC made its now “infamous” move to a neutral monetary policy from an accommodative policy. Within two days of this announcement, the rupee moved further than it had done in the previous 30 days! And it continued to move towards the present level of Rs 64.3/$.

Domestic corporates, domestic economy, domestic retail, domestic investors, domestic growth — all lost because of the MPC. Who gained? Foreign investors, who obtained the largest real “carry” in the world (excluding political and economic uncertainty in Brazil). Borrow at 2 per cent or less in Europe, US or Japan, buy Indian government securities with a 6.7 per cent yield, and yes, don’t hedge your currency exposure. The foreign investor can be seen grinning broadly — what, me worry? How long before an enterprising politician accuses the MPC of being anti-national?

The MPC has tried so many excuses, so many explanations for its behaviour, that it has run out of time, space and credibility. As it played gymnastics with the economy, and jobs, the RBI attempted to clear doubts about its expertise with excuses for its gifts to “foreigners” (paid for by the domestic taxpayer).

First, the MPC broadly hinted that it was going against its own mandate of targeting headline inflation and was now considering targeting core inflation. But most brazenly, it chose to emphasise false core inflation as its target, that is, core inflation including petrol. No central bank in the world targets false core; it seems the RBI felt it was appropriate to do so because oil prices were hovering round $55/barrel and domestic petrol prices were inflating at 18 per cent per annum. So false core was sticky at 5 per cent, as the MPC “rightly” concluded. However, no sooner had the MPC penned this excuse that oil prices (internationally and domestically) began to fall. And, along with it, false core inflation. The April CPI data, released just days after the MPC excuses on April 7, now showed even false core hovering around 4.4 per cent, having declined from 5 per cent a month earlier.

True core inflation — CPI minus food minus energy minus petrol — meanwhile continued its downward trend, 5.3 per cent in April 2016; April 2017, it registered 4.2 per cent.

Why are the MPC assessments so off-base? Very likely because of two factors. First, the RBI seems to be still influenced by the household inflation expectations survey that it conducts every quarter. This still suggests median inflation expectations of 7.5 per cent one year ahead, which means half the sample thinks CPI will be above 7.5 per cent in 2017-18. This survey was junked by Governor Rajan, but seems back in play (whenever the MPC wants to defend tightening).

Incidentally, if the RBI does cite this survey again, it should note that at the MPC rate cut in October 2015, this same household expectation survey signalled a one year forward expectation of CPI inflation of 11.3 per cent.

Rajan started using the Professional Forecasters Survey (PFS) for the modelling of expectations, but while the PFS does have “better” forecasts than the household survey, it is still wide off the mark. In the September 2016 survey, the six month forward forecast of CPI was 4.6 per cent; actual result, 3.7 per cent. In March 2017, the PFS forecast 3.9 per cent for the next quarter, again, with 3 per cent in April and around 2.2 per cent expected in May, the PFS will again score a large miss.

But what do mature central banks do on measuring inflation expectations? They have professional economists who analyse actual past inflation, and other data, to “tease” out inflation expectations. The RBI has very capable staff that can do this analysis; why not utilise that expertise for policy making?

The second major problem with the RBI inflation forecasting model is its heavy reliance (to the point of not thinking) on “base effects”. To date, the RBI has yet to announce ex ante the base effects it is estimating and/or assuming. This would be educational, both for the MPC, and for journalists and experts who take whatever the RBI says as the “truth”. Strange, they don’t take politicians or businessmen at face value, but the RBI is a holy cow for them.

This needs to change and the RBI can help the transformation towards thinking by having a policy statement without mentioning the term “base effects”. Note that base effects analysis is only valid for inflation (or growth) regimes which have no trend. There is no way one can look at CPI inflation over the last three years, or even the last year, as being “flat”.

So, what will the MPC do on June 7? It has two choices: Either not admit to errors of research and judgement, keep its ego intact (I am the boss, we know better, we don’t make errors or, we don’t admit to them) and say that it is looking at the data, the fall in inflation might be temporary, etc. Or, it comes clean, says we introspected, re-examined data, lowered our inflation forecast for the year, hence feel we can tentatively begin to lower rates.

MPC — the whole world is watching. Act responsibly. You are not in D-School any more.

The writer is contributing editor, ‘The Indian Express’, and senior India analyst at Observatory Group, a New York-based macro policy advisory group. Views are personal

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