Column: Breaking the link

Written by Renu Kohli | Updated: Nov 27 2013, 08:26am hrs
First, the clarification: there is no official link between RBIs policy rate and headline CPI inflation. The central bank continues to anchor inflationary expectations to headline WPI inflation, with the medium-term target of around 5%. However, in the current market environment, most analysts believed that CPI inflation had increasingly assumed that role while its formal adoption was being debated by RBIs committee on a new monetary policy framework.

Much of this belief was attributed to the new Governors stated views on inflation, monetary policy actions of twice raising the repo rate by 25 basis points and formalisation of the process to issue CPI-inflation indexed certificates. Market interpretations of these developments were straightforward: The Governor was focused on headline CPI inflation and was trying to develop a link with its policy rate. Here also the Governor had extended an unequivocal cluethat savers must get a positive real return. If that is so, analysts rationalised, RBIs policy rate should at least match up to headline CPI inflation, if not more. And if CPI inflation had to be killed and inflationary expectations to be moderated, which again are highly correlated to CPI, interest rates must go up a few notches more!

Not surprisingly, there was a near-consensus in the market that policy rates would go up; the only issue was whether the central bank would continue with a few more baby steps of 25bps to catch up or go all the way with a few big hikes. While most ruled out the latter and factored in a few more hikes of 25 bps each, none doubted the resolve of the new Governor to take inflation head on and do whatever it would take to rein in persistent price rise. Further buttressing their belief, RBI had produced the first official CPI-inflation forecast in its end-October policy review; one more solid step in the process of formal transition to CPI inflation as its policy anchor.

What, however, surprised analysts was the post-policy interaction with the Governor. To a question on whether RBI would raise the policy rate any further, given the higher, end-of-the-year CPI inflation forecast, the Governor replied the central bank was done with its policy rate hikes, which had factored in this projection; he further clarified RBI would now observe inflation as it unfolded going forward and would only act if the out-turn was significantly different than predicted. Though taken aback by the Governors clarificationsthese didnt quite match up to his perceived image of an inflation fighterthe implications didnt take very long to sink in. The Governors explanation had completely broken the perceived link between the policy rate and headline CPI inflation.

Undeterred when market analysts were supporting the case for a further 25bps hike following higher October CPI headline inflation (November 12), the Governor once again stepped in, the next day itself. Quite contrary to the market focus on headline CPI, he categorically played down the 10.1% headline figure, saying he was heartened by the marginal decline in core-CPI inflation to 8.1% from 8.5% in September, including its falling momentum; in a rather strange way he notified the market that no single data point or number would determine future policy moves. And he emphasised RBI would desist from over-tightening and allow sufficient time for disinflationary forces originating from a weak economy to help stabilise inflation at a comfortable level.

How does one link the policy rate to headline CPI inflation when the gap would be as high as 225 basis points, going by its 10% forecast Has the Governor given a false start Having consistently led the market to believe the way forward is to link CPI and the policy rate, how could he turn back And if he believes there is still a link, how is he going to fight a persistently high CPI inflation if the policy rate was to be much lower than the headline numbers Surely, market analysts remained unconvinced as some of them continued to factor in few more rounds of policy rate hike leading to some degree of confusion.

The bond markets, where monetary policy signals play out, reflect the impact of these beliefs. Following the end-October monetary review and action (25bps repo rate hike, with like reduction in the marginal standing facility rate), long bond yields began to rise. At a stretch of 8.53-8.58% then, the 10-year bond (7.16%) to which long-term interest rates are benched, climbed 6bps daily on average in the following fortnight, shooting up to 9.13% with the October CPI inflation data release. Although the Governors remarks and RBIs OMO auction on November 18 succeeded in achieving some degree of moderation in bond yield, the bench-mark 10-year yield still remained above 9% much to the discomfort of the central bank.

RBI has now sent its firmest signal yet to anchor yields at lower levels. This comes through the issuance of the new 10-year, 8.83% bond, whose cut-off yield at the November 22 auction was set at 8.83% by the central bank. While it was successful in convincing the market on the direction of monetary policythere was no devolutionthe confusion persists as to the benchmark; with two 10-year bonds, yields range from 9% plus on the 7.16% bond, and 8.75-8.83% on the new bond. In line with its attempts to anchor borrowing costs at lower levels, RBI seems set to continue auctioning the new 10-year G-sec; as trading volumes pick-up, this would be the reference point for long interest rates. Starting with corporate bond yields, currently at 9.1% (benchmarked to), falling, lowered borrowing costs would be helpful for growth. This correction by the central bankbreaking the link between headline CPI inflation and its policy rate through firm signallingis welcome.

The author is a New Delhi-based macroeconomist