The Government of India and RBI have formally adopted a Monetary Policy Framework. Monetary Policy Committee (MPC) has six members, three from RBI panel and three nominated by the government of India. As on September 2016, RBI panel has RBI governor Dr Urjit Patel, deputy governor R. Gandhi as in charge of the monetary policy committee and executive director Michael Patra. Government Of India nominated members are Ravindra Dholakia (professor at IIM Ahmedabad),Chetan Ghate ( Associate professor at Indian Statistical Institute Kolkata), Pami Dua (Director at Delhi School of Economics). Henceforth RBI MPC will decide the monetary policy based on votes with the RBI governor having the casting vote.
As per the framework, RBI is given an inflation target as measured by the Consumer Price Index (CPI), combined for Rural and Industrial Segments. Inflation target is 4% with a band of plus or minus 2% till 2021. RBI has to provide an explanation to the government if target breaches both upper and lower bands for three consecutive quarters.
What does this mean for Ten Year Gsec, INR, Sensex and Nifty in today’s macro economic context?
Real Rate of Interest and Ten Year Gsec Yield
CPI inflation is trending at levels of 5.05% as of August 2016 and the RBI has pegged inflation at levels of 5% for end March 2017. Inflation estimates are within the upper end of the 6% tolerance band of the RBI. RBI benchmark policy rate, the Repo Rate is at levels of 6.50% and given that inflation estimates are at 5%, the implied Real Rate of Interest, which is the difference between the one year treasury bill and estimated inflation rate is at around 1.6%. Is this the right Real Rate of Interest or should it be lower or higher? There is no formal Real Rate of Interest target for the economy and there is also no right or wrong Real Rate. Hence, if RBI deems Real Rate at 1.6% as too high for an economy that needs investments, then it would lower the Repo Rate.
Ten year Gsec at levels of 6.80% yields can also act as a measure for Real Rates. Difference between Ten Year Gsec yields and expected CPI inflation is 1.8% and if the bond market believes that RBI will cut the Repo Rate to lower Real Rate then yields on the ten year Gsec will trend down.
The inflation target for RBI has implications for currency management as well. India being an emerging economy witnesses both capital inflows and outflows on the back of falling or rising global risk aversion. At this juncture with global central banks such as ECB and BOJ keeping rates at negative and with Fed dilly dallying on rate hikes, there is a search for higher returns given cheap global liquidity. Capital flows could pick up sharply and RBI would then have to start to sterlise the flows to prevent rising inflation expectations through liquidity driven economy. On the other hand, a strong inflation targeting framework would lend stability to the INR as its internal value will strengthen and that will prevent sharp depreciation of the currency in the face of global liquidity outflows.
Fewer Boom and Bust Cycles
Inflation target is largely positive for Sensex and Nifty as it will provide both investors and businesses confidence on the Indian economy. Investors will face a tempered regime when bubbles and busts do not occur frequently while businesses will have a stronger sense of returns on their investments.
Sensex and Nifty are trading at just below record levels and are likely to trend higher on the back of inflation staying down and prospects of lower interest rates to boost economic growth.
The caveat for inflation targeting is its efficacy. Is there a right inflation level? ECB for long has targeted inflation at 2% but Eurozone inflation is closer to 0% and growth is in doldrums giving rise to the question, was ECB wrong in holding on to its inflation target in the face of economic headwinds?