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Despite persistently weak inflation, which reflects economic slack, markets are pricing repo-rate hikes two years from now. Whereas item-specific exclusions (like food or gold), while used commonly, ignore the substitution effect, median inflation measures, endorsed by academic literature, are less volatile, correlate better with economic slack, and forecast 1Y-ahead inflation better. In India, they currently show very weak trends. And yet, the spike in the 5Y-2Y yield gap implies markets expect a rapid normalization of inflation and rate hikes in two years. Better communication (“lower for longer”), more money injection (M3 and M0 growth have slowed sharply), and lower duration of supply should help.
Measuring underlying inflationary pressures: median to the rescue?
Since Jan-2025 headline inflation has been falling sharply, and core inflation ex-gold/ silver is now sub-3% with weak inflation in both goods and services. That said, item-specific exclusions ignore the substitution effect, and food or gold prices are not the only items with high volatility. A better measure of underlying inflationary pressures in academic literature (references on page 5) is median inflation: it is less volatile, correlates better with economic slack (output gap) and forecasts 1Y-ahead inflation better; “asymmetric trimmed-mean” further improves on this; both suggest inflation is well below target.
Market pricing implies a quick return to 4% headline inflation; what about slack?
Despite monetary easing, the 5Y-2Y yield gap has widened, likely as markets expect a rapid return to 4% inflation, and thence normalization of policy, i.e., rate hikes in two years. This may be premature, in our view, as fiscal consolidation continues, and it is unclear how many years of above-trend growth may be necessary to absorb the economic slack visible in disinflationary pressures. MPC emphasizing downside-risks to future inflation projections thus may help in transmission. Excessively long duration of issuance and a fall in T-bill supply have also unduly steepened the yield curve needs changes.
More monetary expansion essential at this stage: excess money drives inflation
In our view, a major driver of below-optimal inflation, which signals persistent slack, has been constrained monetary expansion – broad money (M3) and base money (M0) growth have slowed sharply. When record FX sales (in CY22, 2HCY24 and CY25) destroyed deposits and raised wholesale funding costs, these were not replenished via bond purchases by the RBI. This policy mix constrains monetary easing and adds growth risks. Recent INR moves show that RBI has started taking incremental steps to address the balance between monetary policy independence and currency stability, as the capital account stays open (Impossible Trinity).
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