Why inflation undershot expectations

The dramatic and sustained disinflation India has witnessed over the past three years is the most stark manifestation of the macro-economic transformation the economy has undergone. It's also, however, the source of an important macroeconomic puzzle. 

One constant in the past three years has been that actual inflation has consistently undershot expectations. Put differently, forecasts of inflation have consistently over-estimated inflation (or underestimated the disinflation) - thereby making systematic forecast errors. Consider this: Consensus CPI forecasts predicted 7.7 per cent inflation for 2014-15. The actual outturn was dramatically lower at 6 per cent. Yes, oil prices fell later that year, but that should have been offset by the drought in 2014. There were no mitigating circumstances the next year. Consensus forecasts pegged inflation at 5.4 per cent in 2015-16. Despite another drought, the actual inflation outturn was just 4.9 per cent. Again, in 2016-17, forecasts pegged inflation at 5.2 per cent. The actual outturn was materially lower at 4.5 per cent. I suspect we are on course to another undershoot this year.

It's not so much the magnitude of the forecast errors, but the fact that they were consistently one-sided that constitutes the puzzle. What could we driving this? We proffer four drivers. 

Food disinflation more structural than believed? The unsung hero in India's disinflation is food. After averaging 11 per cent between 2007 and 2013, food inflation has secularly declined to average just 4.5 per cent since 2016. Four elements are noteworthy. First, it occurred despite successive droughts in 2014 and 2015. Second, it is broad-based, and not just driven by one or two food groups. Cereals, pulses, and high-protein items have all seen substantial disinflation. Third, the amplitude and duration of the perishables inflation cycles (fruit and vegetables) have reduced sharply. Fourth, the food disinflation is not simply because of lower oil prices and transportation costs. The disinflation started before oil, and has endured even as oil jumped from $35 to $50.

What all this hearteningly suggests is there is a structural component to the disinflation, likely attributable to muted increases in minimum support prices (MSPs), a debottlenecking of food supply chains in recent years, and pro-active measures by the government to fight shortages with imports.

This is not to say that cyclical factors are not at play. Weak demand is also likely a factor. The acceleration of food inflation – particularly high-protein items – in the mid-2000s was also a consequence of buoyant rural demand. The flip side is also likely true. Rural demand has remained depressed in recent years – as evidenced by the softening of real rural wages – and that weaker income growth has likely translated into ebbing demand for food items (The “Engel curve” effect). Similarly, global food prices have seen a meaningful decline since 2014 and may have also played a part. The implication is as these factors reverse food inflation could partially mean-revert.

Notwithstanding that, with every passing quarter of softening food inflation, there is growing conviction that there is a structural and enduring element to it — assuming the muted MSP increases are here to stay. One important collateral benefit of declining food inflation is that household inflationary expectations are strongly influenced by food. Therefore, the sustained food disinflation is likely having a salutary impact on expectations.

This phenomenon has likely been a key source of the systematic forecast errors. Forecasters have likely presumed at each turn that the food disinflation would mean-revert, something that has not materialised as yet.

The negative output gap is larger than we think. Compounding this is the likelihood that the degree of slack in the economy is likely more than believed, with the implication that firms have even less pricing-power than thought. “Output gaps” are notoriously hard to estimate in emerging markets. One proxy for the output gaps, therefore, is the behaviour of core inflation (though, strictly, core inflation captures both the quantum of the output gap and the slope of the Phillips curve). After adjusting for gasoline and diesel prices core inflation has seen a gradual but sustained slowing, softening by another 100 bps over the last year to print at a series-low of 4.1 per cent in April. This would suggest the negative output gap is larger (or that demand is weaker) than presumed by inflation forecasters.

Changing commodity market dynamics.  Commodity market dynamics have also fundamentally changed in recent years. The oil market appears to have gone from having a floor to having a ceiling, with the advent of shale. Similarly, China’s secular slowing and attempted re-balancing has kept a lid on metals prices, and with financial conditions tightening in China the outlook on commodity prices appears less threatening. Perhaps this “new normal” has not been fully incorporated into forecasts.

Disinflationary forces from the rupee. A fourth factor is that the recent rupee appreciation (a consequence of the capital that has flooded emerging markets since the start of 2017) has also likely also imparted disinflationary forces. We estimate that the rupee’s 5 per cent appreciation against the dollar – if sustained – will soften CPI by about 40 bps. Of course, this could easily reverse, and so cannot be relied upon.

All told, a number of forces have likely contributed to inflation systematically undershooting forecasts. To be sure, some of these simply reflect weak demand and will eventually reverse. But there also appears to be a structural element to the disinflation that has likely been under-appreciated. This is important because we find that inflation expectations in India are highly adaptive and react to inflation from even eight quarters past. With inflation averaging less than 5 per cent over the past two years, it is likely to have some salutary influence on expectations. If so, it would imply that even when the output gap eventually closes, the mean-reversion of inflation may not be as vicious as in the past.

This is not to claim victory on inflation. Far from it. The inflation-targeting regime is still in its infancy, and so there's no room for complacency. But the evidence is building up that if the good work on MSPs, food supply chains, and positive real rates continues, we may just be witnessing an important downshifting of inflation and expectations in India — for which policy makers deserve enormous credit.
 

The writer is the chief India economist at JP Morgan. Views are personal