The July CPI number continues the recent run of persistently high and upwardly surprising prints. Food inflation had started to jump up from October 2019 and has averaged 10.5% since then. Core CPI has started to rise as well after March of this year, from stable 4%ish range to now close to 6% in the latest reading. These developments have understandably dented the quantum and timing of market’s rate cut expectations.
First Principles of Monetary Policy
Data collection and predictability issues are manifesting around the world, leading to wide differences between forecasts and prints. To that extent India isn’t unique. We have released a detailed note on CPI internals (https://idfcmf.com/article/2538) that indeed suggest data issues. Hopefully, these will get resolved down the line and the economic significance of such data will then begin to increase. Extrapolations become somewhat lesser meaningful for the same reason since just as data has broken out in one direction somewhat quickly, it can reverse course with equal alacrity as well. In the meanwhile, and with the tools at hand currently, it is important to remind ourselves of some first principles and also of the broader narrative.
Monetary policy largely addresses the following two inter-connected channels, in our view:
1. It influences general financial conditions and via that aggregate demand. This in turn impacts inflation for a given level of supply in the economy.
2. It adjusts incentive to savers via an adequate real compensation, basis the underlying macro-economic construct.
If arguments against further easing are based around the aggregated demand channel, then proponents of this line of thought also need to dissuade the government from any aggregate income enhancing efforts for now. This is because if supply constraints are so large that price rise is showing despite a once-in-two-lifetimes growth shock, then income raising efforts have to be first preceded by alleviating those constraints. At the very least, such measures shouldn’t then be considered on aggregate but only provided specifically as compensation for work done around de-congesting certain supply channels. Second, the criticism that government did too little in terms of first round stimulus also has to be abandoned and the acknowledgement made that it has been proven right in not ramping up the stimulus in the presence of stifling supply constraints. These arguments are put here largely to demonstrate the risks from generalization in the current context.
Lowering of effective real compensation and thereby swinging balance somewhat more in favor of the consumer of savings without changing nominal rates, is the only rationale reason for no further easing in our view. Indeed, we are broadly quite sympathetic to the savers’ repression argument (https://idfcmf.com/article/2300). However, one has to differentiate between a structural requirement from a cyclical one (or medium term from short term). Thus while structurally we need adequate savers’ compensation to be able to sustainably finance our large investment needs, cyclically we are saddled with excess savings and therefore savers’ compensation is of little consideration for now.
Aggregate Demand Agnostic Inflation?
CPI has now been elevated since December. Meanwhile the bottom has fallen off of growth and (likely with a lag) of incomes. Indeed, economists generally agree that even if jobs are coming back they are at the cost of incomes (urban and many non-agricultural rural jobs offer much higher incomes than agriculture). If that kind of a shock couldn’t curb our CPI then it is clearly asking for too much for the humble monetary policy to be able to make any contribution. This also is the greatest reason why the phase of elevated CPI currently is more noise than anything else and should be largely looked through for purposes of monetary policy setting. However, there may be urgent signals here for supply chain management. Indeed, apart from the data noise, basis currently available information we would attribute this phase of higher CPI to higher taxes on fuel and “sin” goods (by definition redistributive and without second order effects on inflation), the recent massive run-up in gold prices, and extreme congestions in specific supply chains (also showing as wide variations between wholesale and retail prices). The following charts help depict the extra-ordinary noise embedded in the data:
Source for all charts: CEIC, IDFC MF Research. Note: 1) All charts depict %month-on-month of non-seasonally adjusted data. 2) Apr20 and May20 data points in all charts are shown in green colour as they were officially calculated using imputation methodology.
Meanwhile, In The Real World…
Finally, it has been our view for some time that conventional policy via rate cuts is firmly on a path of diminishing marginal utility. Even from a market standpoint a further 25 bps fall in effective overnight rate would have led to very small gains on the rest of the curve. Rather it is the forward guidance, liquidity stance and unconventional policies that are from here-on the more potent tools in the policy toolkit. One hopes that policy adopts a practitioner’s approach and doesn’t dilute the effective deployment of these. For yields what matters is RBI’s support for the borrowing program, which so far has been relatively ‘light touch’, and not so much the prospects for further rate cuts. The current local and global template is not one for nuances and it is our base case that such support will be forthcoming from the central bank in line with this template. A fortified external account (https://idfcmf.com/article/2508) provides more than adequate cover for RBI, while a collapsing local credit growth environment provides a relatively strong commercial demand framework for bonds.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the stocks may or may not continue to form part of the scheme’s portfolio in future. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.