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RBI Considers Leading Indicators

The concept of 'output gap', regularly used by the members of the Reserve Bank of India's Monetary Policy Committee to explain the rationale behind their decisions, is "virtually unusable", according to Lakshman Achuthan, co founder and chief operations officer of the Economic Cycle Research Institute.

"We do not believe that, in practical terms, this is a useful approach to the assessment of underlying inflation pressures," Achuthan told Cogencis in an interview.

The Economic Cycle Research Institute, a consultancy that prides itself for regularly pinpointing "when the cycle will turn", has almost always been cited in the minutes of MPC meetings, with external member Pami Dua quoting the economic indicators of the New York-based organisation.

The output gap measures the deviation of the potential from the actual level of output. If the actual output is higher than the potential level, the output gap is said to be positive and vice-versa, with inflation tending to increase when the output gap is positive.

According to an analysis conducted by the institute, even in countries, like the US, where good data is available, the output gap concept is "badly flawed".

As such, this makes the use of the concept in India even more untenable, given that policymakers at home have been rather vocal about the paucity as well poor quality of the available data.

It is probably not very surprising then that the assessment of the output gap by the RBI's rate-setting panel, which will detail its third bi-monthly monetary policy statement for 2017-18 (Apr-Mar) on Wednesday, has been rather mixed.

In June, external member Chetan Ghate said the output gap might have widened in recent months. Ravindra Dholakia went a step further, saying the output gap was large.

RBI Deputy Governor Viral Acharya favoured this interpretation, saying that a negative output gap seemed to be opening up.

On the other hand, RBI Executive Director Michael Patra expected the output gap to "narrow and close" in the current fiscal.

Governor Urjit Patel was the only one to mention that assessing the output gap was difficult.

"Not only does it (output gap) not have the reliable relationship with interest rates and inflation that the Taylor rule would indicate, but also it is subject to substantial revisions that could be of the same magnitude as the output gap itself," Achuthan said.

The institute's leading indicator approach differs from standard econometric models in that the latter project patterns in recent past data to the near future. This, Achuthan said, can result in reasonably accurate forecast models. However, a big weakness is that any error will get magnified at the time of a cyclical peak or trough, when the trend changes.

"...thus an extrapolative approach would logically fail," Achuthan said, citing an International Monetary Fund study that concluded that "the record of failure to predict recessions is virtually unblemished".

What the institute's leading indices provide, Achuthan said, are early warnings of turning points in economic cycles. "Because monetary policy acts with the well-known 'long and variable lags', such an approach can provide vital insights, especially in the lead-up to a turn in the cycle."

While the institute's indices have policy implications, Achuthan refused to make any recommendations as far as the RBI was concerned.

He, however, did say that as per the institute's Indian Future Inflation Gauge, inflation pressures "should not be a major issue" for the latest meeting of the MPC.

Consumer Price Index inflation, the MPC's nominal policy anchor, hit another all-time low of 1.54% in June--the eighth month in which it stayed below the medium-term target of 4%. Consequently, the MPC is widely expected to announce a 25-basis-point reduction in repo rate on Wednesday.

The RBI, having come under fire for its inflation forecasts in recent months, made a sharp downward revision in June. The central bank now sees CPI inflation at 2.0-3.5% during Apr-Sep, down from the earlier projection of 4.5%, and at 3.5-4.5% for the second half of 2017-18, compared with 5.0% pegged earlier. CPI inflation has averaged 2.2% in Apr-Jun.

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