The Reserve Bank of India (RBI) recently cut its CPI inflation projections for Q3 FY19 sharply, by 90bps in October and 120 bps in December. It cited ‘heightened short-term uncertainties’, amidst unusually low food inflation and volatile crude oil prices. In this context, we look at RBI projections in the last one year – the magnitude of its revisions, directional bias (if any) and precision when compared with the actual numbers. However, for a holistic and fair evaluation of the projections, it is important to factor in the economic context and the corresponding uncertainties it entails. For this, we do a detailed study of the RBI’s fan chart of CPI projections – from the bi-monthly Monetary Policy Committee (MPC) resolution statement – to gauge the RBI’s thinking about the future CPI trajectory, the underlying degree of uncertainty in its projections and how this changed in the last one year.
What do the fan charts tell us?
Figure 1: RBI’s fan chart of quarterly CPI projections
Source: RBI (MPC resolution statement, 5th December 2018). Note: Data for the 50% CI range is obtained based on visual observation.
The RBI’s fan charts on quarterly headline CPI projections (Figure 1), tell us two things – 1) the baseline projection (also mentioned in the statement text) and 2) how confident the RBI is in its projections. For the latter, we look at the range of outcomes associated with a particular probability of occurrence. For e.g., the 50% Confidence Interval (CI) below, on which we focus our study in this note, implies there is 50% probability that the actual outcome will be within the range represented by the thick red shaded area. Higher the width of the range (upper bound minus lower bound), greater the uncertainty or lower the confidence.
To decipher the trend in the direction, magnitude and uncertainty of projection-revisions, we look at the data through a series of charts below. Important to note is the RBI’s CPI projections that matter most are the antepenultimate (second before the last) and penultimate (one before the last), given the final projections are either made well into or after the quarter ends.
Upside bias despite sharper downgrades
Figure 2 depicts the CPI projections for a particular quarter vs. actual, at the last 3 MPC meetings when the forecast for that quarter is provided (after which actual data becomes available), and the economic context.
Source: RBI. Note: Q3 FY19 actual data is the average of October 2018 and November 2018 readings.
The key observation is:
- The consistent upside bias (over-estimation) in RBI’s projections from Q4 FY18. However, it must be noted that most estimates on the street during the period were also high, given food inflation has stayed unusually soft.
Uncertainty fuels volatility while the unusual fuels the margin of error
Higher uncertainty (crude oil price, exchange rate) and the unusual (soft food inflation) has defined India’s economic landscape in the last few months. The impact of this feeds into projections as well. See Figure 3 below, which depicts the magnitude of difference in RBI’s projections vs. actual.
Figure 3: Recent revisions – impact of the uncertain and the unusual
Source: RBI. Note: Q3 FY19 actual data is the average of October 2018 and November 2018 readings.
We observe:
- Revisions have been quite heavy and volatile
- The margin of error, particularly in the projections for the last 2-3 quarters, have been high
- The upward bias in projections
To understand this further, we look at the 50% CI range-width for the last three projections of a quarter (Figure 4). While lower width represents lower uncertainty, it should be noted that the width typically reduces as we move into the quarter because actual CPI and market-price data becomes available. Q2 FY19 was an exception, a sheer case of heightened short-term uncertainty.
Source: RBI. Note: All CPI fan-chart related data is based on visual observation of the chart in the MPC policy statement
We now look at uncertainty from a different angle. For this, we address the question ‘How confident has the RBI been, at each of its MPC meetings, when making CPI projections for the immediate three quarters?’.
Figure 5: Uncertainty when making projections at the last nine MPC meetings – above average in August and October 2018
Source: RBI. Note: Dotted lines above depict the average for each of the category.
Two major inferences from Figure 5 are:
- High fluctuation in the degree of confidence within current and next quarter projections vs. quarter-after-next projections
- Jump in average uncertainty from the current quarter to the next quarter projection, but only a moderate increase from the next-quarter to the quarter-after next projection.
Thus, although the RBI’s confidence is higher when making current quarter projections (which is reasonable given availability of concurrent data), it’s degree is very volatile. Particularly, August 2018 and October 2018 witnessed a sharp fall in RBI’s confidence when making current and next quarter projections. However, as we mentioned earlier, a fair and holistic evaluation of the projections demands an understanding of what transpired in the real economy. In this regard, the table below (Figure 6) captures the volatility in specific economic variables then and how this justifies some of the uncertainty RBI faced. Nevertheless, the magnitude of revisions, the margin of error and even the general upward bias are all still debatable.
Figure 6: Economic variables at the last four MPC meetings
Source: RBI, CEIC, IDFC MF Research Note: Red color = Increase; Green color = Decrease
The bottom line
Fan-charts, of particular interest due to RBI’s recent sharp downgrades of CPI projections, reveal critical information. The key takeaways from analysing the charts released by the RBI in about the last one year are:
- Consistent upside bias in projections, despite sharp downgrades
- Sharp revisions to projections more recently
- Higher margin of error (vs. actual), especially in the last 2-3 quarters
- Higher short-term uncertainty evident from episodes of a) higher confidence in projections revised in the wrong direction and b) increasing uncertainty (ideally should be decreasing) about a quarter
- Volatile degree of confidence when making current-quarter projections; particularly low confidence recently at the August 2018 and October 2018 MPC meetings
- The uncertainty around crude oil price and the exchange rate, and the unusually soft food inflation, partially justifies the recent revisions but their magnitude, margin of error and general upward bias are debatable
Finally, there could be two types of errors:
- The first is caused by the false-perception of higher certainty. This could cause an error in the directionof the projection made (e.g. the penultimate projection for Q4 FY18).
- The second is caused by higher uncertainty. This could cause revision in a projection, despite being in right direction, to be insufficient in terms of its magnitude (e.g. revisions in projections for Q3 FY18, Q1 FY19 and Q2 FY19).
Based on the above episodes, it seems the RBI is committing more of the latter. However, this could be because the unusual persistence of softer food inflation continues to surprise.
Thus, it is important to keep in mind the above inferences when interpreting RBI’s CPI projections and acknowledge the higher scope and margin for error during uncertain times.
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