The RBI shocked, nay pleasantly surprised the bond and stock markets. It drastically cut its inflation forecast for the first half of the current year by half a percentage point to 4.7-5.1% from 5.1-5.6% in February.

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It further cut the inflation forecast for the second half of the year (Oct-March) to 4.4% from its earlier forecast of 4.5-4.6% . Given that the RBI’s or rather the MPC’s mandate is to keep inflation close to 4%, this forecast effectively means there is no rate hike for at least one year. Indeed since the RBI’s Monetary Policy Report ( a document that it puts out twice a year, given its inflation-targeting mandate) forecasts FY20 inflation at 4.5% chances are there are no rate hikes for the next two years.

The RBI doesn’t say why it has cut the inflation forecast so drastically. Perhaps it is because inflation in the just ended quarter i.e March 31, is mostly coming at 4.5% , a good half a percentage point lower than the 5.1% that RBI forecast. Much of this is because of the unexpected crash in food prices. Looks like RBI has merely worked this into the April-September forecasts.

It is a little more difficult to explain the cut in the inflation forecasts for the second half. Although it is a minor cut, it is bewildering because, the government has promised to increase the minimum support prices for crops to 1.5X the production cost.

Economists believe such an MSP can well push up inflation by half a percentage point. Of course these are guesstimates, but it is fair to assume that the RBI also fears some hike due to MSP; it mentions this as a risk to its forecast.

What is more, the government has also indicated that it is preparing to implement the MSP diligently by paying farmers the difference between the market price and the MSP, with states bearing part of burden. Dr Ashok Gulati, a former chairman of the agricultural prices commission estimates that if market prices are 10% below MSP, the government’s scheme will cost Rs 43,700 crore, and if they are 20% below MSP, the cost to the exchequer could be Rs 87,400 crore. This means that the other risk the RBI points to its estimates, higher-than-expected fiscal deficit from states and centre, is a threat that will most likely be realized, especially in an election year.

Also, the RBI has assumed that crude prices will be around $68. There is a good chance that crude prices are even higher. Interestingly the RBI dovetails its inflation forecast with only upside risks. It hasn’t mentioned a single downside risk. All this clearly arouses skepticism about this 4.4% forecast.

Though, to be fair the RBI governor said at the outset, that he will be data dependent.

So is the RBI merely taking a gamble. The strong speech of the deputy governor on Jan 14 had scared away banks from the bond market.

The yield curve steepened to historic highs, as a result, the difference between the overnight repo rate and the ten year yield climbed to 160-175 basis points for a better part of February and March, versus a usual spread of say 70 basis points. This jump in yields threatened to jeopardise growth and more importantly the government borrowing programme.

In the past two weeks the government and RBI have taken two significant steps to bring down bond yields. First the government cut its first-half borrowing programme by 22% and hugely reduced the amount of long-term bonds that it plans to sell. Then the RBI moved in and allowed banks to provide for their mark-to-market bond losses in FY18 over four quarters instead of doing it in the quarter when the loss was incurred. This benign inflation outlook could be seen as an effort to push through the first half government borrowing programme.

Afterall the RBI, as the governor said today, is always data dependent. If the MSP impact on food is high and the fiscal deficits are larger than budgeted, the RBI can always raise its inflation forecast in the August or in the October policy.

There is, hence, a bit of uncertainty for markets in the second half of this year. Inflation could be higher than forecast exactly at the time when the government will be borrowing more than it usually does in that part of the year.

Of course, the RBI’s gamble may pay off and food inflation may indeed remain benign due to perhaps globally soft food prices, which experts say often rubs off on Indian food prices.

That said, what is uncomfortable about the RBI's forecasts is the wide variation between two consecutive policies. What changed so much in two months that RBI cut its inflation forecasts so much.

Again, in the February policy, the RBI spoke of the need to “nurture” the “nascent economic recovery”. And just sixty days later it speaks about declining output gap in the economy and growing investments. That’s simply too much variation between two consecutive policy statements.

Finally, what was most inexplicable today was not anything in the RBI’s statement but what happened in the press conference that followed. Seven journalists got a chance to ask questions and not one uttered the word PNB or ICICI!

First Published:Apr 6, 2018 9:19 AM IST