RBI plans to roll out demand-supply mismatch index to forecast inflation rates

Researchers at the Reserve Bank of India (RBI) have planned to roll out a demand-supply mismatch index to forecast inflation rates, according to the central bank’s Working Paper titled An Alternative Perspective on Demand. The paper has been authored jointly by Saurabh Sharma and Ipsita Padhi. According to the researchers, this index has a causal relationship with headline inflation and “is found to be a competing predictor of headline inflation, as compared to other conventional measures of slack such as the output gap and level of capacity utilisation.”

The index focuses exclusively on the inflation-forecasting properties of demand and supply. “Any mismatch between demand and supply has implications for the trajectory of inflation. While supply disruptions would pose an upside risk to inflation, demand shortfall is expected to depress inflation,” it states.

But how does this demand-supply mismatch index calculate inflation? It also mentions that when any economy faces both demand and supply shocks at the same time, future trajectory of inflation will be decided by factoring in the relative severity of both these shocks. For instance, if the impact of demand shortfall outweighs the impact of supply disruptions, then inflation would be moderate.

The researchers analysed impulse response of output to average demand and supply shocks over 15 quarters. This analysis “suggests that most of the impact of demand shock fades away within 5 quarters while the impact of the supply shock persists for more than 15 quarters,” according to the RBI Working Paper. 

Researchers have also decomposed GDP growth into demand and supply components. Since the business cycle has been broken down to demand and supply components, the estimated indices capture short run demand-supply conditions. This paper also proposes a new framework for identifying demand-supply using sectoral outputs and input-output linkage measures.

The estimated demand-supply indices represent demand and supply in 4 ways – estimated supply is found to be more persistent than estimated demand; estimated demand is found to more volatile than estimated supply; estimated indices are in line with the major demand and supply events in the economy like the Global Financial Crisis, the Taper Tantrum, etc.; a demand-supply mismatch index (constructed simply as estimated demand minus estimated supply) is found to a competing predictor of inflation vis-à-vis other conventionally used measures of excess demand.

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