BondYields,CPIDataandMeasuringtrueinflation

Yesterday we wrote about the US elections and Nate Silver predictions. Timing couldn’t have been more spot on as yesterday US President Trump chastised Silver in one of his tweets for his “forecasting skills”. Moving on to the state of the markets, the Dow Jones was up last night as tech shares were flying. Though we have given the stimulus reason umpteen times earlier too, we will again today present it as a causal point for market rise. The White House, pushing for the passing of a stripped down version before the election in absence of a broader consensus, was the main news doing the rounds.

Domestically, we had the big news of CPI data for the month of September. The CPI came at 7.3% against the consensus estimate of 6.9%. The number again is more than the RBI comfort band of 4%+-2% and pushes the rate action further into the future. In case the inflation number starts coming down on the back of base effect (or cooling down of food prices) in coming months then the expectation of rate action for the Feb policy will still be justified. Analysing the data point in further detail, the major cause of the rise in inflation was a broad-based jump in food inflation. Food and beverages form close to 45.86% of the CPI basket under which vegetables constitute a 6.04% share. The spike in vegetables was sharp.

We have written multiple times previously that inflation is one the major gods in the pantheon of macro economics. Economists of all hue study it in detail and try to model the impact on various monetary policies. In India there was a lively debate when the anchor inflation benchmark was changed from WPI to CPI stating how effective one can think the monetary policy can be in controlling food inflation which forms a lion’s share of the CPI basket. The logic given was that the CPI, as it mirrors the common man’s consumption basket, is the true representation of the price rise faced by him (or her). WPI on the other hand gets constrained in capturing correct inflation levels because of disparate retail markups on the goods as they pass from producer to consumer. It is not as if the policy makers don’t know all this lacunae but it represents the best compromise.

In the book Principles of Economics, Ben Bernanke and Robert Frank delve into the topic of inflation in great detail. Talking about the case of the US where many social security benefits are linked to CPI levels they touch upon the problem of basket construction. For any CPI to convey any meaningful information two things are important -  the base year and the basket of goods. This basket then remains the same until the series is over. Bernanke and Frank write that the goods in the basket may improve in quality over a period of time. For example, if it has an item like a personal computer, then there is no way to capture the improvements in technology which go inside the computer. Maybe for a slightly higher price the customer is now getting a remarkably better machine. A controversial study by Michael Boskin studied this phenomenon in detail. We will discuss that in a later note.

On the Indian bond markets front, the yields continued moving leftward building on the positive sentiment post the MPC. With the 20k Cr INR OMO due this week it will create further demand for bonds. 10 year benchmark bond closed at 5.90. It opened today around the same levels.