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The official anchor of Indian monetary policy, the wholesale price or WPI indicator, was quietly buried on January 28 this year. There was no formal announcement by the central bank, which however dropped WPI inflation projections and outlook from its policy statement and Review ofMacroeconomic and Monetary Developments. A price objective of 8% CPI inflation by January 2015—with a 25bps increase to align the policy rate with CPI-core inflation—replaced WPI, although a formal adoption of CPI as nominal anchor (recommended by the Urjit Patel committee) was not announced. The central bank’s loss of confidence in WPI was evident in disappearance from WPI inflation fan charts, prospect for achieving end-March inflation objective, and so on. Text references to WPI were all that remained of the 60-year old index that until now guided monetary policy.
In itself, WPI’s fadeout as nominal anchor isn’t any surprise. For the index was progressively ignored by stealth ever since year-on-year retail inflation numbers became available from the new CPI index, constructed especially for monetary policy purposes. As the two charts show, RBI’s policy rate (repo), steadily diverged vis-à-vis WPI from January 2012. The repo rate was completely aligned with core-CPI inflation by August-September 2012.
But the transition was unclear then as both headline-WPI and core-CPI inflation rates were almost equal at around 8%. And as the accompanying chart shows, long-term interest rates were unaffected by this quiet, uncommunicated transition—the yield curve flattened as the 10-year benchmark bond-yields continued to track the official anchor, headline-WPI inflation even as short-term interest rates were anchored upon a higher policy rate in this phase. In fact, as year-on-year WPI inflation dropped to 4.58% in May 2013, yields on the 10-year paper or lesser duration fell below the central bank’s policy rate of 7.25%, while primary market yields in the 10-year bond auction corrected even more sharply.
From the viewpoint of real economic activity, where long interest rates matter, this was a significant development but one that was short-lived. The external environment changed dramatically: Foreign capital flows abruptly reversed; the exchange rate sharply dropped; short-interest rates were hiked 300bps in response; and inflation pressures returned.
The effects upon domestic conditions and policies were equally sharp. As calm restored and emergency measures were gradually withdrawn, RBI utilised this opportunity to switch completely away from WPI. In this short and swift transition phase, the central bank presented gradual reduction of the