Although the new RBI Governor, Raghuram Rajan has already said that clarity on this matter will emerge once the monetary policy framework committee (Chair, deputy governor Urjit Patel) submits its report in three months time, many market analysts have raised their future repo rate guidance, anticipating RBI will eventually walk the talk and make the transition to adopt the new-CPI as its future monetary policy anchor. The fall out of such forward-looking policy guidance by the analyst community has run tangential to the central banks own guidance on a neutral policy rate stance. The resultant steepening of the yield curve at the long-end has made RBI uneasy; the devolvement in primary auctions was a case in point.
The moot question is: What leads the market analysts conclusion that RBI, under a new Governor, will end the WPI-CPI uncertainty and make a formal transition even when the monetary policy framework committee has barely got off the ground The answer, somewhat strange, is analysts belief that the new Governors mind is made up in favor of the new CPI and the transition will be formalised in the new, forthcoming monetary policy framework. This appears a strange case of market uncertainty where the new Governors stated policy position has few takers, but his perceived future position has gained sufficient credibility!
Three distinct pronouncements by the new Governor, which analysts understand to be convincing, specific leads, have shaped their views. The firstwhen the new Governor took over at Mint Streetwas the announcement of the CPI-Inflation Indexed Savings Certificates for retail investors to be issued by end-November. This looked perplexing with WPI-indexed bonds already in the market; while interested buyers would focus upon the higher returns from such bonds/certificates, the declaration caused confusion from a monetary policy perspective.
More importantly, this pronouncement seemed to extend legitimacy to a price index whose reliability and stability was under scrutiny by the very institution! Just a month ago, ex-Governor, D Subbarao, had categorically stated the new-CPIs limitations, explaining why RBI must stay with the WPI while making a calibrated transition, in his last speech (Statistics in RBIs Policy Making- Conceptual and Empirical Issues, August 30). Those who carefully read the speech were fair to conclude the WPI-CPI uncertainty was settled where monetary responses mattered and, therefore, further speculation on this was unwarranted. Not surprising then that the CPI-indexed certificates surprised many, while bringing alive the WPI-CPI debate once again. Some interpreted this as a signal that, unlike his predecessor, Rajan is more comfortable with the new-CPI and ready to adopt it as a policy anchor.
Two, these expectations gained further ground with the surprise 25 bps repo rate hike at the RBIs mid-quarter review; this was linked, but not explicitly, to high retail inflation and its role in entrenched inflationary expectations. The third clinching lead is the recent reference to new CPI-core inflation (viz. CPI stripped of food, fuel prices) by the Governor on the sidelines of an event: this has become a market buzz - the die seems cast, as it were, by RBI to formalise its policy link vis--vis the new CPI.
One must again emphasise that these are not really clinching pieces of evidence, but mere perceptions of a segment of market analysts driven by anxiety to see through the transition. Nor did Governor Rajan ever say anything that materially deviated from RBIs stated position on the matter. Issuing CPI-linked certificates, for example, could be for the limited purpose of weaning retail investors from goldthese might be just certificates, not market-traded bondsso it may be premature to attach much significance in a monetary policy formulation context. Likewise, the September 20 rate hike could well be justified by an anticipated reversal in WPI headline inflation. And the reference to CPI-core shouldnt have been surprising as RBI always looks at all kinds of inflation.
Importantly, it is a bit nave to think that the monetary policy framework committee will overlook the new-CPIs limitations pointed out by the former RBI Governor as these are very specific: lack of robustness, dominance of supply side factors and inadequate data coverage for services price indices. Neither do these become irrelevant with change of guard at Mint Street, nor do they change colour to align with a new policy frame work! These are purely data limitations that must be addressed, without which a robust policy framework would lack credibility.
To highlight one such instance of data susceptibility, the core-CPI and core-WPI are plotted alongside. The core-CPI remains at around 8% since July 2012a prolonged period of 14 months in which core-WPI inflation declined quite sharply. What explains the relative stickiness of CPI-core (comprising mostly services activities) since July 2012 Why didnt services inflation fall when the sector itself is witnessing sharp demand deceleration reflected in the successively weaker quarterly growth numbers After all, the services sector is unlikely to suffer from supply constraints, the traditional explanation for food inflation. Can a wage-price push be explanation enough, while the same isnt true for the manufacturing segment Can we rationally explain this behaviour If not, is the data itself suspected Is it possible the new CPI-core is overstating the true inflation
There isnt an attempt to conclude anything here but only to highlight that without some credible answers to these emerging trends, it would be risky for the RBI to make any hasty transition to the new-CPI for monetary policy. While appreciating the new-CPIs appealits core component measures inflations for services, almost two-thirds of Indias economy, hitherto missing from the conventional WPIit is crucial to recognise that it is this very component that is under scrutiny: If it remains unrepresentative, as the ex-Governor noted, will the new-CPI ably fulfill all the robust features so essential for credible policy guidance
While the RBIs focused fight against inflation and inflationary expectations to restore stability to the internal and external value of rupee is respected, we suggest the new monetary policy framework committee extend its considerations to the new CPIs limitations and factor in how much of a handicap these could be. For articulating a red line in terms of the new CPI could run the risk of locking the economy into a very high policy rate regime in the short to medium-term if average food price inflation persists above 10% as in past few years, given supply constraints and unresponsive political economy, and services price inflation exhibits stickiness at around 8%, as the new CPI index continues to evolve.
Renu Kohli is a New Delhi-based macroeconomist