Watch out for the CPI rate-shock

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SummaryRBI using CPI instead of WPI will lock the economy into a very high policy rate in the short- to medium-term

A question dotting the financial market space once again is if RBI is increasingly leaning towards retail inflation for monetary responses, preparing the ground for dumping the conventional WPI index in favour of the new CPI index to anchor inflationary expectations. What if headline WPI inflation declines from a good harvest but CPI inflation remains high? Will RBI ignore any seasonal correction in the WPI and raise the policy rate further to align it closer to the new CPI? These questions, revolving around the WPI versus CPI inflation debate, have led to a fair degree of uncertainty in recent weeks as to what will drive future monetary policy action.

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 bank’s 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 Governor’s 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 Governor’s 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 first—when the new Governor took over at Mint Street—was 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

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