Headline inflation numbers surprised on the downside again in October, by printing at 3.31%. The numbers undershot the market consensus and, importantly, the RBI forecast again, raising doubts over the inflation forecasts as laid out by the central bank. To be fair to RBI, the volatility of oil prices makes the forecasting of inflation a difficult job, but of late the persistent decline in food inflation has made the forecasting exercise a nightmare, even for market participants.

Interestingly, RBI’s CPI projections were off the mark most of the times (particularly in the period of volatile oil prices and, of course, vegetables), with actual inflation being much less than what the central bank had projected. One can, however, always argue that, as a central bank, inflation forecast tends to be on the higher side and this is done ostensibly with the purpose of tempering inflationary expectations. However, if future inflation projection is kept higher, it may prevent inflation expectations from declining significantly, even as actual inflation may continue to fall.

In the US, members of the Board of Governors and Federal Reserve Bank Presidents come up with their projections of the most likely outcomes for real output growth, the unemployment rate, and inflation for each year and over the longer run, based on their individual assessments of the appropriate path for the federal funds rate. Whereas, in India, the Monetary Policy Committee (MPC) reviews the surveys conducted by RBI to gauge consumer confidence, households’ inflation expectations, corporate sector performance, credit conditions, the outlook for the industrial, services and infrastructure sectors, and the projections of professional forecasters. The MPC also reviews, in detail, staff’s macroeconomic projections, and alternative scenarios around various risks to the outlook. Drawing on the above and after extensive discussions on the stance of monetary policy, the MPC adopts the resolution.

But even after all this, what is most important is the uncertainty surrounding the CPI forecast made by the MPC. It is interesting to see what forecasting technique the MPC members adhere to. In the Indian context, standard univariate ARIMA (autoregressive integrated moving average) time series forecasting or even macro modelling may not work. For instance, generating forecasts under (and often unstated) assumptions about exogenous variables such as oil prices, government spending, and global growth will throw up illusory or elusive results.

Under such circumstances, it may be better for the MPC to work with short-term forecasts for the next three to six months, as macro-variables like oil prices are now almost difficult to predict. One must remember the oil price crash in FY15 that had resulted in inflation undershooting RBI projection by more than 300 basis points in December 2014.

Next, the story on food prices. For several years now, the consistent decline in food prices remains a mystery. When the Centre had announced an increase in minimum support price (MSP), a plethora of research reports contended that such MSP hikes could add, on an average, 50-70 bps to inflation, or even higher. However, in the month of October, market prices of most crops have moved away further from MSP. Interestingly, the price movement post July 2018 (the month when the government fixed the price of MSP crops) shows an opposite trend, where except paddy, cotton and sesamum, the rest of the kharif crops are trading at significantly lower than MSP.

In between, the government announced the new procurement policy under the umbrella scheme PM-AASHA (Pradhan Mantri Annadata Aay SanraksHan Abhiyan), with the aim of ensuring remunerative prices to farmers for their produce as announced in the Union Budget for 2018. In fact, the government has also increased the budget provision for overall procurement cost at Rs 15,053 crore, and simultaneously an off-balance sheet additional government guarantee of Rs 16,550 crore. It seems that the procurement of such crops may not be happening at the pace required.

The other interesting trend that defies logic is the jump in core inflation numbers. However, a closer look at core inflation numbers reveals a contrasting story on the rural and urban front. In rural areas, the jump in core inflation is much muted, with the maximum increase coming from the transport subcomponent driven by fuels. The health sub-segment has witnessed a jump that is higher in rural areas, than in urban areas. This is a positive social change, as it shows that in keeping with trends across countries, poor people, when they have money in their accounts (read Jan-Dhan), spend more on health and try to circumvent the behavioural bias of spending less on intoxicants. This is clear from the accompanying table. The Ayushman Bharat scheme (Pradhan Mantri Jan Arogya Yojana) may act as an enabling factor in this case, as the maximum jump has come through in the month of October. But what is worrying is that rural folks may be cutting back on discretionary spending (clothing and footwear) to compensate for the expenses on fuel (clothing and footwear contribution has declined by a sharp 20 bps), recreation and even education to a limited extent!

Clearly, a constellation of factors may now enable inflation to decline even below 3% in the following months. Oil prices are unlikely to gain on the back of a muted global demand. Food prices are unlikely to recover significantly unless the government gets into procurement on a war-footing. Core inflation is also set to decline as demand is moderating. All this means that we are back to April 2018, when RBI had given out a benign inflation outlook, only to change it subsequently in June and August.