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A Long Pause - Outside View by Arvind Chari

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A Long Pause
Aug 18, 2014

The RBI, under Dr. Rajan, seems all set to move towards becoming a 'soft' inflation targeting central bank. The comments made by the finance minister and the RBI governor post the recent Annual Board meeting of the RBI suggests that the new government and the RBI are on the same page regarding the changes recommended by the RBI in adopting a new monetary policy framework.

To understand how monetary policy functions and its impact on the common man; read this Monetary Policy and You

The Urjit Patel committee set up to review the monetary policy framework had recommended in January a move to targeting headline Consumer Price Index (CPI) as the nominal anchor for monetary policy and had given a 'glide' path over the next 2 years to bring CPI inflation down to below 6% and with an eventual target of 4% (+/- 2%)

The recommendation, if accepted by the government would thus make RBI join a growing list of EM countries with an explicit inflation target. The committee had unequivocally recommended using the Headline Consumer Price Inflation (New Combined) as the inflation target.

Given that 57% of the weight in CPI is Food and Fuel, it is almost irrelevant to consider Core CPI (ex food and fuel) as a measure of inflation target. Given that, households experience inflation at the retail level and that Wholesale Price Index (WPI) does not include services (which is 55% of GDP); the CPI seems to be the correct choice as a barometer of overall inflation in the country.

Chart I : WPI / CPI Divergence
(Source : RBI; MOSPI; Min of Industry and Commerce)

RBI has traditionally used WPI inflation as a measure for setting interest rates; for instance the sharp rate cuts post Lehman crisis in end 2008/ 2009 was needed and moved with the fall in WPI. But as you can see in the chart above CPI (blue line) actually increased after a very small drop. In hindsight, RBI should not have cut the interest rates by so much and should have also hiked a lot earlier in its cycle,. The RBI, then in 2010 was hoping for the food prices to fall after the monsoon shock which came but by the time even WPI rose sharply.

The neglect by the RBI of the high and sticky CPI and household inflation expectations in the last three years and moving the Repo rate based on movements in WPI has been pointed as a big policy blunder and the eventual currency weakening in 2012/2103 and falling savings is pointed out as the fall out of keeping interest rates lower than inflation.

Chart II & Table I : Low 'Real' rates lowers financial savings/ increase gold
investment and widens CAD and Inflation was not only a supply side problem
India's Inflation Problem is not only supply driven
CAGR % Increase Period
Land Prices (largely rural)(*) 26% since 2000
Domestic price of Gold (*) 13% Since 2000
Govt. Agricultural Support Prices 9% 10 years
Govt. Subsidy and Social Spending 17% 10 years
(Source – CMIE; (*) Economic Time article- 12 Nov 13 )

The RBI, under Rajan despite not having an official target has already begun the process of anchoring the monetary policy to CPI. The 3 rate hikes between September 2013 and February 2014 was to align the Repo rate to counter the inflationary situation. The subsequent 'pause' since then @ 8% Repo rate is also indicative that the RBI is getting more confident of achieving the near term CPI target of 8% by January 2015.

Chart III & IV: CPI Inflation target of 6% seems daunting and
hence RBI likely to remain on a long pause around the 8% Repo rate mark.

(Source : MOSPI; RBI ; Quantum Data and calculations; all data y-o-y)

The chart above shows the CPI inflation trajectory and over the past 2 years. The green line is the current Repo rate of 8% and also the CPI target for RBI for to be achieved by January 2015. The important thing though is the Red line. The CPI target of 6% to be achieved by January 2016 as per RBIs stated intention.

The chart on the right suggests the apparent difficulty. Food prices, especially vegetable prices have been unbelievable volatile. The blue line on the right chart is headline CPI –yoy. The green line is the CPI when calculated after removing the impact of vegetable prices. That has seen a steady decrease in inflation rates suggesting that overall prices pressures are easing. But for the volatile trend in vegetable prices, and because it also occupies media attention and your daily consumption, the inflation expectations at the household level has remained high. And the RBI has to guard against that.

"The Reserve Bank will continue to monitor inflation developments closely, and remains committed to the disinflationary path of taking CPI inflation to 8 per cent by January 2015 and 6 per cent by January 2016. While inflation at around 8 per cent in early 2015 seems likely, it is critical that the disinflationary process is sustained over the medium-term. The balance of risks around the medium-term inflation path, and especially the target of 6 per cent by January 2016, are still to the upside, warranting a heightened state of policy preparedness to contain these risks if they materialise"

This statement by the RBI in its recent monetary policy review is very clear in its intent that they would keep interest rates at 8% till the time they are comfortable in achieving the target of 6% by January 2016. It also suggests that if the inflation increases the RBI can even hike interest rates.

Given that monsoons have recovered well and that for second year running government has hiked MSP prices by less than 5% (avg..) should mean that some staple food prices like rice; wheat; pulses should soften by early next year. I believe given this trajectory of CPI, I expect it to fall in the coming months. But to the corporates dismay, that would not lead to rate cuts. Given that I have had high inflation for so long and that it is finally coming under control; it is important for the RBI to not celebrate early and thus I still seem to be in for a long pause by RBI @ 8% till CPI goes well below the 7.0% mark and remains there.

So given this whats the impact on you as an individual.

The desire to provide 'positive Real Rates' to savers needs to be realized and thus it is imperative that interest rates remain high and attractive for a period of time incentivizing investors to plough back their savings back into financial assets and away from Gold.

So for savers in fixed deposits, given that the repo rate will hold @ 8% for some more time, one should expect deposit rates to remain around the 9% mark. This when seen from the reported and expected CPI inflation of 7% for next year; the 9% rate seems definitely attractive. It may be prudent to increase the tenor of your fixed deposit investments beyond the 1 year and lock into these rates for longer tenors.

The same holds true for investors in bonds and money market through liquid and income funds. Given that RBI will hold interest rates @ 8%; bond yields at or near the 9% rate should be attractive to commit ones capital. If the expected CPI inflation downtrend materialises and as market starts expecting rate cuts to flow through, investment in an income fund where in the bond portfolio built at current yield levels of 9% should offer potential double digit returns over the next 1 year as interest rates fall.

From a borrowers perspective though, EMIs on your home and auto loans are unlikely to come down in a hurry. And one should plan the finances keeping in mind that the EMIs are likely to remain the same or even higher depending on the entity one has borrowed from.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.


The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view. The views expressed here in this article are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Information sourced from third parties cannot be guaranteed or was not independently verified. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date.

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