Column: Shaping the yield curve

Written by Saugata Bhattacharya | Updated: Dec 17 2013, 10:32am hrs
Based on the inflation printsboth CPI and WPIfor November, superimposed on comments by the RBI Governor over the previous month, it seems likely that RBI will increase the repo rate on December 18. There is also little doubt that while most of the surge was confined to selected food items, there are concerns about this spilling over into a more generalised inflation. The channels for a potential wage-price spiral are not difficult to foresee: CPI-inflation-linked dearness allowance increases for public sector employees and pensioners, for instance, adds to a significant transfer of funds, which might be characterised by a higher propensity of consumption, adding to demand.

Many issues have periodically been raised about the efficacy and desirability of using a blunt instrument like repo hikes to address what is perceived to largely be a structural problem, constraints in agricultural and labour markets due to logistics, lack of efficient storing and transport, and (more controversially), cartelisation at selected points in the value chain. But, as the Governor recently reiterated, We can spend a long time debating the sources of this inflation. But ultimately, inflation comes from demand exceeding supply, and it can be curtailed only by bringing both in balance. We need to reduce demand somewhat without having serious adverse effects on investment and supply. This is a balancing act, which requires the Reserve Bank to act firmly so that the economy is disinflating, even while allowing the weak economy more time than one would normally allow for it to reach a comfortable level of inflation.

How might this balance be operationalised Two questions are important. First, what are the objectives of tightening monetary policy and what instruments are best suited to achieve these objectives Second, monetary policy, by nature, is a forward-looking exercise, with long leads required to turn economic activity. How much might RBI need to tighten further Projecting the growth-inflation dynamics is a very state-contingent exercise in the present context, and getting the signals right over different time horizons is a complex and difficult exercise.

Parsing the Governors statement above for the first question, it is clear that firm action demands a signal via interest rate increases, but calibrated so that cost of funds do not unduly increase to choke off a capex-led growth recovery. This indicates a 25 basis points (bps) rate increase instead of a steeper 50 bps or more. What purpose might this serve The core of the strategy is to divert demand from consumption towards investment. One action, more concrete than just signalling, is to steepen the yield curve, bringing short-term rates lower, so that effective cost of funds for lending not just drop close to repo rates (leading to cheaper funding) but are also less volatile (leading to better planning of credit disbursement). This intent seems to be reflected in recent RBI signals on liquidity infusion and pricing term repos, as also the use of prudential tools to incentivise targeted credit flows to SMEs and exports. At the same time, to ease the fiscal space for allowing better transmission of monetary policy, the cost of borrowing for the government might be sought to be increased, to incentivise a reduction of the fiscal deficit, thereby further releasing credit to productive sectors.

The second question is, what happens going ahead One compelling reason to keep rate hikes moderate is the possibility that inflation, both CPI and WPI, begins to come off in the near term, driven by falling prices of vegetables and cereals. In the medium term, though, this drop might not continue, with a modest growth revival giving legs to increasing pricing power for goods and services, resulting in more broad-based inflationary pressures. Even if this revival is due to capex, price pressures will emerge in the near term, with capacity-driven supply easing only over the next couple of years.

Does this view square with prospects for a growth revival this year and the next, which are likely to be very modest Smaller companies have shown signs of recovering, with their balance sheets showing better debt ratios and better operational cost control. However, in general, capacity addition is likely to be very slow. Corporate financials have deteriorated over the past couple of years and will take some time to deleverage, bring in fresh equity and start investing. As a result, even a modest revival in demand will push up prices.

The external environment is yet another dimension to the rate decision. It is very likely that a taper will happen over the next couple of months, which will induce some volatility. But India is better prepared for the inevitability, with both a lower current account deficit and improved investor sentiment. Consequently, the need to stringently align the domestic yield curve with the US is lower. Hence, even if rates are not increased further, the prospects of rate cuts are somewhat low.

In conclusion, RBI will likely increase the repo rate by a modest 25 bps, signal its readiness to hike more if inflation persists, continue its liquidity stance to move the operational rate closer to the repo and target increased credit flows to selected segments. These will be reinforced by measures to deepen capital markets for risk handoff and containing asset quality stress.

The author is senior vice-president & chief economist, Axis Bank.

Views are personal