By: Punam Sharma
The recently concluded RBI policy, the first under Governor Urjit Patel and the newly constituted monetary policy committee (MPC) format, has left much food for thought for markets, economists, and commentators. After the first round of mulling over, the consensus seems to be that the bend of policy is decidedly towards further easing. With the dust settling down on the policy, we think it appropriate to highlight a few key points and potential investor implications.
1. The importance of 4+/-2% target band: At the last policy review, it has been clarified that the ‘self imposed’ RBI target of 4% by March 2018 is no longer valid now that the 4+/-2% band has been officially notified. Presumably owing to this, the MPC found room to cut rates even though RBI staff projections are of a 4.5% CPI in Q4 2017 – 18 (it is to be noted that even this 4.5% number doesn’t include the direct or indirect impact of the house rent component of 7th Pay commission). However, some amount of confusion in the analyst community has persisted; and this seems chiefly owing to the following: in theory an inflation target band should work towards ensuring that cyclical / event related shocks can be absorbed without the central bank having to react in terms of drastic changes to its policy setting. Thus for instance if our average CPI was indeed trending towards 4%, the RBI could have been assured that even in the case of an adverse event like an oil price spike or a monsoon shock, inflation could have been contained within the 6% outside limit. Instead, the central bank seems to be expressing comfort effectively with a CPI between 4 – 6% even when we are experiencing significant cyclical disinflation currently. Today we are experiencing the beneficial price effect of a good monsoon even as rural wages still remain depressed, the full effect of centre and state pay awards and consequent consumption thrust is still ahead of us, and global commodities are still relatively depressed. Even with these strong cyclical tailwinds if the centre point of the CPI band is unachievable and the central bank remains in easing mode, there is possibly a case to wonder what happens down the road. The argument then is not whether the RBI is unjustified in pursuing the range rather than the mid-point. It is rather this that if at probably peak cyclical disinflation we still cannot think about the mid-point, then what probability do we have of defending the range over longer periods of time. This is especially true when, as RBI’s own surveys indicate, household inflation expectations remain exceptionally volatile. A related point, made recently by some economists, is with respect to the appropriate reaction function of an inflation targeting central bank. Again the theory goes that the central bank should only respond to near term or recent history inflation prints, if those prints contain some information about the likely trajectory of inflation over the medium term. It is worth examining the recent inflation trends from this standpoint. It is now well documented that despite a collapse in rural purchasing power and excess industrial capacity, our so called core part of CPI (excluding all components of food and fuel) has persistently refused to budge below the 5% handle. Instead the bulk of disinflation last month and what is expected in the months ahead, is coming from massive actual and expected disinflation in pulses and vegetables. The problem is that if farmer realization on pulses is allowed to collapse like this, the incentive to grow will diminish next year and prices will rise again on shortage. Indeed, the plan seems to be to continue to raise minimum support prices (MSP) on pulses and step up procurement to both build buffers and protect farmer realization so that there is no avenue for shortage down the line. Hence, there seems to be little information in the current bout of disinflation on what prices may be in the future. For this reason, some believe that it may be inappropriate for RBI to act based on ‘opportunistic’ episodes of disinflation. Instead these may be used to create further disinflation buffers so that unwinding of these triggers down the line don’t invite an adverse reaction function from a CPI targeting RBI.
2. The concept of ‘real’ rates: Under the Rajan era, and after many iterations, the real rate framework broadly got defined as the rate on 1 year treasury bill minus average expected inflation. The RBI’s preference then was said to be 1.5 – 2% real rate. This has been tweaked by the new regime which says that, given global realties of lower real rates, one can even target a lower real rate of 1.25%. Now there seem to be two problems with respect to executing this framework: One, it is difficult for the RBI to target a particular level of CPI while simultaneously giving out a real rate guidance. Thus under Rajan if the RBI was serious about achieving the 4% target but wasn’t confident about it going there, it certainly couldn’t have afforded to cut rates further; even though had that target been achieved the real rates in the system would have been much higher than the guidance band of 1.5 – 2%. This problem is less difficult in the new regime since, if the RBI is targeting an inflation range rather than a point, it has more flexibility to honor both the range as well as the real rate target. However, this convenience may not exist down the line when cyclical disinflationary pressures have run their course. Two, CPI in India is still very volatile and extremely difficult to predict into the future. This is evident from the width of the RBI’s own fan-chart on CPI projections. In such a circumstance, a real rate guidance based on future average expected inflation can get very tricky. To take an actual example, the market expects CPI prints over the next 6 months to substantially undershoot RBI’s assessed trajectory. If this were to happen, there is a strong likelihood that participants start expecting delivery of 1.25% real rates over these ‘seasonally depressed’ CPI prints. Indeed, it is possible that such expectations have already begun taking hold. It then becomes very difficult for RBI to guide commentary, if future inflation prints revert closer to what is the more persistent underlying trend. This, then, is the potential hazard of putting in public domain an at best nebulous concept, as a guiding factor for future policy expectations.
The RBI is certainly well within its rights to re-interpret its mandate with a change in regime. The point here has been only to point out some aspects of this re-interpretation and potential outcomes down the line. For investors, the takeaways from our stand-point are these: It makes sense to position for continued near term bullishness given 1>that near term CPI prints are probably poised to fall much more than is being projected by RBI staff, 2> it seems reasonably clear that the new regime has chosen to interpret the FIT mandate more benignly. However, there do remain two points of caution: One, there is a chance that the global environment turns more volatile with some doubts cropping up on further G3 easing as well as with event risks like the US elections around the corner. If heightened volatility indeed comes to pass, then India being an emerging market will have to weather its own share of volatility. Two, as risk free and AAA rates fall further investors shouldn’t continually dilute their risk filters in an attempt to secure better yields for their portfolio. Rather, first the level of desired risk should be ascertained and then portfolio decisions should be made; even if this means somewhat lower returns than recent history.
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