In itself, WPIs fadeout as nominal anchor isnt any surprise. For the index was progressively ignored by stealth ever since year-on-year retail inflation numbers became available from the new CPI index, constructed especially for monetary policy purposes. As the two charts show, RBIs policy rate (repo), steadily diverged vis--vis WPI from January 2012. The repo rate was completely aligned with core-CPI inflation by August-September 2012.
But the transition was unclear then as both headline-WPI and core-CPI inflation rates were almost equal at around 8%. And as the accompanying chart shows, long-term interest rates were unaffected by this quiet, uncommunicated transitionthe yield curve flattened as the 10-year benchmark bond-yields continued to track the official anchor, headline-WPI inflation even as short-term interest rates were anchored upon a higher policy rate in this phase. In fact, as year-on-year WPI inflation dropped to 4.58% in May 2013, yields on the 10-year paper or lesser duration fell below the central banks policy rate of 7.25%, while primary market yields in the 10-year bond auction corrected even more sharply.
From the viewpoint of real economic activity, where long interest rates matter, this was a significant development but one that was short-lived. The external environment changed dramatically: Foreign capital flows abruptly reversed; the exchange rate sharply dropped; short-interest rates were hiked 300bps in response; and inflation pressures returned.
The effects upon domestic conditions and policies were equally sharp. As calm restored and emergency measures were gradually withdrawn, RBI utilised this opportunity to switch completely away from WPI. In this short and swift transition phase, the central bank presented gradual reduction of the marginal standing facility rate through September-October as monetary easing, while moving its policy rate closer to CPI-core inflation by successive 25bps increases. There were also occasional references to CPI inflation, although interspersed with WPI references, which created confusion. There was the September announcement of introducing CPI-linked bonds, which eventually launched in December; this currently is a savings instrument and not traded so far. CPI-inflation projections followed at end-October, side-by-side with those of the traditional WPI-inflation. Finally, WPI was completely eliminated from the monetary policy radar in January this year, when just CPI-inflation projections, outlook, etc, appeared and were discussed along with monetary action. With this, the transition to CPI was complete. So was the quiet dispatch of WPI to the backburner.
The shift from WPI to CPI as nominal anchor has resulted in nearly 170bps increase in 10-year yields between May 2013 and January 2014, or in eight months. As the accompanying chart traces, the 10-year yield on the benchmark government paper had not remained immune to the emergency interest rate hikes in July-August 2013climbing nearly 100bps to around 8.47% by end-Augustanticipating a depreciation feed-through into domestic inflation. But they were still tracking WPI inflation right until October. As CPI inflation forecasts surfaced in RBIs meeting of October 28, 2013 however, long-bond yields detached from WPI, as market beliefs shifted to the CPI indicator.
As can be observed from the chart, despite the sharp corrections in WPI inflationDecembers 6.2% and Januarys 5.05%the yield curve has not responded to the decline. Instead, the yield curve steepened as 10-year yields have risen to 9% and beyond; they shot up to 9.19% the day after RBIs January 28 meeting. At an average 9.04% last month, the 10-year benchmark bond yield average is now tracking CPI inflation, completing the link between monetary policy and long-end of the yield curve.
In fact, the day after RBIs seminal monetary review in which it made clear it was looking at consumer-price inflation, the central bank had to scrap the WPI-linked bond auction as investors demanded higher yields, noting the shift to CPI as nominal anchor. Markets feared they might be saddled with these bonds, whose trading might become illiquid given that CPI was now the key gauge. Despite RBI Governor Raghuram Rajans explanation in the post-policy interactionthat the central bank was far from accepting the UPC recommendationsthe market perception of CPI as monetary policy anchor remains unchanged.
But are the new linkages between the monetary stance, inflation-output dynamics and the transmission mechanism established yet That doesnt appear to be the case so far. Prime lending rates of banks are broadly unmoved in response to monetary policy signals: the average base rate has inched up just 10bps in response to a cumulative 75bps tightening from September last year. In contrast to the evolving monetary policy stance in past few months, prime lending rates of banks are on average 30bps lower relative to a year ago. Eventually, the 10-year bond yields, now kissing CPI, would at some point of time, force up lending rates.
WPI, as it was known to markets and the general publicthe reference indicator for monetary policyhas ceased to exist. It may remain around for other reasons, e.g., national income accounts. But its role in monetary policy formulation is over. As this old price index recedes into history, the interaction of Indian monetary policy, CPI inflation and relationship expectations, and the credit market will be fascinating to observe and study.
The author is a New Delhi-based macroeconomist