Split within RBI MPC flags flawed inflation model…A case of too soon?

Anirban Nag has a piece reflecting on the recent MPC split. He says the core problem behind split is the inflation model which is out of sync with Indian reality.

…the split raises questions on how much trust the MPC members place in the monetary authority’s forecasting model, which has consistently overestimated price pressures. 

The RBI’s inflation assessments have come under intense scrutiny after a slew of readings fell short of projections. Prime Minister Narendra Modi’s Chief Economic Adviser Arvind Subramanian criticized forecast errors that he said are “large and systematically one-sided in overstating inflation,” and called on policy makers to take a long, hard look at June’s record-low 1.5 percent reading.

where the RBI’s model is probably flawed is that it is structured around the concept of a small, open economy, according to Rohan Chinchwadkar, assistant professor of finance and accounting at the Indian Institute of Management at Tiruchirapalli in the southern state of Tamil Nadu. That would be akin to $300 billion Singapore, while India is a $2 trillion behemoth where almost half of gross domestic product is generated by an intricate web of unregistered networks that employ more than 90 percent of workers. 

“This might be one of the causes of disagreement within the RBI,” Chinchwadkar said. “There is no clear model understanding of the impact of monetary policy and shocks on India-specific features like the informal sector and shadow economy. So the position of MPC members depends on their own judgment and risk preference.” 

The central bank’s staff published a working paper in November in collaboration with the International Monetary Fund, aiming to “sketch out a model with India-specific features to capture the dynamics relevant to an emerging market economy.” It concluded that forecasting performance is improved by using the Bayesian statistical technique which assesses the probability of something happening based on observed data. 

The current model is based on the principles of New-Keynesian economics, which evolved from classical Keynesian economics but differs in terms of how quickly prices and wages adjust. It consists of four variables: the output gap, the Phillips curve which assesses the impact of unemployment, the Taylor rule for short-term interest rates that also guides several global central banks, and interest rate parity through exchange rates.

When India moved towards the new monetary policy framework recently, it was suggested that India joins the ranks of advanced countries. Gone are the days where policy was driven by experience and discretion and now is the era of rules and models…

Now we are told that the model does not reflect Indian reality and one has to go back to the drawing board.

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