Sunday, December 29, 2013

Expectations from Revised Monetary Policy Framework

RBI Governor, Raghuram Rajan, during his much celebrated September 4 market interaction informed about the formation of a committee under Deputy Governor, Urjit Patel, for proposing changes to the existing monetary policy framework.  This revised framework was expected to be released in 3 months time.

Since 3 months have since elapsed, market speculation about the likely release of the new framework has kept the Indian rates market under check with extremely reduced duration risk appetite and trading volumes.

The key outcome of this revised framework could be

  • The new 'inflation' anchor to the monetary policy rates. Currently, RBI uses the WPI as the main policy anchor with a 'comfort' level (not a target) of 5%; must admit RBI also looks at Core WPI and CPI amongst other inflation measures.  
  • Preferred liquidity management tool: OMO or Term Repos?

Inflation Anchor
In the new framework, RBI might shift the inflation anchor - following are the options:
This is a shift which will make Indian inflation numbers comparable with the rest of the world; simple for not-so-sophisticated portfolio investors to look at 'real' yields across countries. The main drawback of the CPI measure is its volatility - with food having close to 48% weightage in the index, the headline CPI is subject to swings based on seasonality or frictional factors impacting food.  Setting policy rates on a volatile index is definitely undesirable.

WPI to Core CPI
On more than one occasion, Raghuram Rajan has cited the trends / levels of Core CPI as one of the reference point for the monetary policy decision.  With core CPI actually reflecting household inflationary expectations, I expect this to be the likely choice of inflation anchor for RBI.  There are some calls by research houses that RBI might choose Core CPI minus Housing as housing has not shown interest rate sensitivity in the last 5 years: but, in my opinion, over a longer observation period, real estate and housing are definitely sensitive to interest rates and the complete Core CPI should become the monetary policy's preferred inflation anchor.

Liquidity Management: This would be of particular relevance to bond traders and mutual fund managers. Till the introduction of term repos, RBI typically uses purchases in Open market operations (OMO) to infuse liquidity into the banking system. OMOs had been used even for frictional liquidity stresses like advance tax outflow windows. But with term repos, the requirement for OMOs have somewhat been reduced. RBI had been looking at OMOs only if liquidity stresses were seen to be longer than just being frictional - say stress for 2-3 months. If term repos are extended beyond 14 day tenure to 30 day / 60 day tenures, the need for OMOs would be drastically reduced. OMOs would then be used only in times of primary liquidity withdrawal like USD sales or lack of growth in M0 is hampering credit offtake.

Indian yield watchers are keenly tracking this. Shift to Core CPI as inflation anchor and employment of longer tenure repos are likely to be bond negative.  Are we taking the new 10Y benchmark to 9+ yield levels?

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