Ignoring CPI inflation to set rates can be costly: CLSA

The RBI is widely expected to ease rates today based on WPI inflation while CPI inflation remains worryingly high. In an interview to CNBC-TV18, Rajiv Malik said a decline in WPI core inflation will play a greater role in policy but high inflation remains a concern.

A CLSA note said issuance of inflation-linked bonds will probably be duds if the yardstick used for inflation remains WPI. CLSA warns that ignoring CPI inflation for setting policy rates will be costly as banks will find it difficult to attract deposits, and monetary transmission will be compromised.
CLSA maintains that the 10-year bond yield would decline to around 7.30 percent later this year. Monetary easing, OMOs and weak credit demand will be positives for bonds.
"Bond-yields have risen since the FY14 Budget at the end of February. This is mainly because of the impact of the announcement of bond buyback. The buyback is expected to replace shorter-term bonds with longer-dated paper. The goal is to create more room for potential open market operations (OMOs) and also to reduce rollover risk," he adds. Below is an edited transcript of the analysis on CNBC-TV18 Q: The consensus is that there will get 25 bps repo rate cut. How strong is the case for a pause in this policy?
A: The only pushback for a rate cut is the high Consumer Price Index (CPI) inflation. Bear in mind, back in January when the Reserve Bank of India (RBI) cut both the cash reserve ratio (CRR) and the repo rate. CPI inflation was high but not as high as it had been in February. The rather idiosyncratic approach the RBI follows with giving greater weight to Wholesale Price Index (WPI) rather than CPI means that the decline in core inflation on the WPI will play a greater role in setting the interest rate as opposed to CPI and hence the case for a rate cut. Q: Is the RBI governor not happy with the way the economy is shaping up?
A: It is possible. But this time around the RBI governor has been uncharacteristically positive in terms of what the Budget has delivered so far. Q: Transmission of the cut in rates has been a problem for this market and for banks generally. How much transmission do you expect to see from anything the RBI does and how much impact in terms of loan growth?
A: Transmission does not necessarily need to take place the same day. Transmission is likely to be limited by banks window dressing their accounts for the fiscal year-end, the quarterly advance tax outflows will have their impact and finally, the large cash balances with the government. But by early April, a lot of these factors are going to reverse and that is when banks really will begin to pass on some of these benefits.
There is also really no compelling case for a CRR cut. I know the finance minister has already indicated the RBI pay attention to liquidity concerns, But I think the USD 800 billion in cash balances and the initial impact of the advance cash outflow makes the underlying core liquidity shortfall in the liquidity adjustment facility (LAF) not all that worrying to prompt a CRR cut.