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 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-CPI?s limitations, explaining why RBI must stay with the WPI while making a calibrated transition, in his last speech (?Statistics in RBI?s 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 RBI?s 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 RBI?s stated position on the matter. Issuing CPI-linked certificates, for example, could be for the limited purpose of weaning retail investors from gold?these might be just certificates, not market-traded bonds?so 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 shouldn?t have been surprising as RBI always looks at all kinds of inflation.
Importantly, it is a bit na?ve to think that the ?monetary policy framework? committee will overlook the new-CPI?s 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 2012?a 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 didn?t 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 isn?t 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 isn?t 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-CPI?s appeal?its core component measures inflations for services, almost two-thirds of India?s economy, hitherto missing from the conventional WPI?it 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 RBI?s 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 CPI?s 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