The Importance of Inflation Expectations

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1 The Importance of Inflation Expectations Deepak Mohanty Mr. Mohanty in his speech, discussed the theory and practice of defining inflation expectations; the measures of inflation expectations, and analyzed the measures of inflation expectations in India. He began by defining inflation expectations as economic agents' belief or views or perceptions about inflation in the future. There are two ways of forming inflation expectations. The first is a variant of adaptive behavior wherein expectations are formed by extrapolating the past and current experience into the future. The second way of forming inflation expectations in a forward-looking manner is rational expectations. Underscoring the importance of inflation expectations, the Reserve Bank's Second Quarter Review of Monetary Policy noted that a central premise of monetary policy is that low and stable inflation and well-anchored inflation expectations contribute to a conducive investment climate and consumer confidence, which is key to sustained growth on a higher trajectory in the medium-term. Focusing on measurement of inflation expectations he said that the measures used by central banks can be classified as market-based measures and survey-based measures. Addressing some of the measurement issues he said that inflation-indexed bond is a market based measure of inflation expectations. The differential yields between ordinary and inflation-indexed government bonds of similar maturity provide an indication of inflation expectations. Second, inflation expectations can also be derived from the yield curve of ordinary bonds of different maturities. The expectations theory implies that the shape of the yield curve depends on the expected pattern of short-term interest rates. Third, the survey-based approach of measuring inflation presents both short-term and long-term forecasts on inflation and covers different target groups, including households or professional forecasters. Fourth, conducting consumer surveys to gauge consumer confidence including inflation expectations using different sampling techniques such as pure panels and repeat panels. Fifth, the Survey of Professional Forecasters (SPF), which forecasts macroeconomic variables in addition to inflation, viz., gross domestic product, interest rates and unemployment rate is another important source to gauge the inflation expectations. Talking further on issues pertaining to measurement of inflation expectations in India, he added that in the recent years, the Reserve Bank has been assessing the state of inflation expectations through a series of surveys aimed at different economic agents as well as model based inflation forecasts. First, the Reserve Bank has been conducting a survey of inflation expectations of households since September 2005 to get a measure of the public pulse on inflation. Second, this survey presents their Speech by Deepak Mohanty, Executive Director, Reserve Bank of India at S.P. Jain Institute of Management& Research, Mumbai, 9th November

2 SPEECH current perception of inflation as well as their expectations about the near future. Third, the consumer confidence survey gives an assessment of the consumer sentiments on prices. Fourth, the Reserve Bank's conducts the survey of professional forecasters since Fifth, the survey of inflation expectations from producers, presents an advance assessment on economic and industrial environment based on the qualitative data collected from select manufacturing companies. Finally, the results of the above surveys are used as inputs for monetary policy formulation and are placed on RBI website for public dissemination. He then moved on to evidence on inflation expectations as revealed by various surveys. The inflation expectations survey of households was dominated by food price inflation. The increase in price expectations with regard to household durables was the lowest. This trend was observed for households' 3-month and 1-year ahead price expectations. However, the inflation expectations of households are their own perceptions based on their consumption basket and do not directly correspond to any official measure of inflation and is reflected in significant heterogeneity across households within the survey. The forecast of professional forecasters is considered rational as all available information is processed, including the central bank's likely reaction function to arrive at medium- to longterm inflation forecasts. Also, the professional forecasters' long-run inflation expectations have been influenced by the trend in actual inflation. He further pointed out that the manufacturing companies' assessment of changes in selling prices for the current quarter and expectations for the ensuing quarter obtained from the industrial outlook survey are well correlated with the year-on-year changes in the price level of non-food manufactured products component of WPI. The Reserve Bank has developed several measures of inflation expectations which provide important inputs for monetary policy formulation. In order to reinforce this process, Mr. Mohanty made a few suggestions. First, the inflation expectations survey of households should be extended to semi-urban and rural areas of the country to enhance its representation. Second, it is important to introduce bonds that provide investors a hedge against inflation in the Indian debt market to get a pulse of the market-based inflation expectations. Lastly, improving the quality of surveys and extracting market information about inflation expectations by analyzing the results of various inflation expectations surveys and financial market variables such as yields and futures prices. In conclusion, he said that peoples' belief about future inflation is an important factor in shaping inflation trends. The professional forecasters, who are considered more rational, have moved up their inflation expectations. In , professional forecaster's medium- to long-term inflation expectation which was in the range of percent was subsequently raised to a range of percent. This underscores the need that the current level of inflation ought to be brought down to better anchor inflation expectations which is vital for maintaining price stability in an enduring manner. Source: 29

3 The Financial Innovations That Never Were V.K. Sharma Executive Director, RBI In his speech, Shree V.K. Sharma expressed that responsible financial innovation is not an end in itself, but instead, a means to an end of sub-serving the real sector and, is consistent with, and a natural fit to, public policy purpose of financial sectorreal sector balance. He however, voiced that it was the unsustainable financial sector-real sector imbalance due to certain financial innovations that was the real cause of the global financial crisis. He covered the evolution of three financial innovations proxied by three derivative instruments in India, viz., Interest Rate Swap (IRS), Credit Default Swap (CDS) and Interest Rate Futures (IRF). Laying emphasis on the IRS market, he remarked that the Report of the Committee on Financial Sector Assessment noted that the notional principal amount of outstanding Interest Rate Swaps of all commercial banks increased from `10 trillion+ as on 31st March 2005 to `80 trillion+ as of 31st March However, due to trade compression, involving multilateral early termination, by the Clearing Corporation of India Ltd. (CCIL), the notional principal amount of outstanding IRS of commercial banks declined to `50 trillion as of 30th June Further, a granular analysis revealed that of all the commercial banks engaging in IRS, public sector banks with about 74% of total bank assets accounted for less than 2% of notional principal amount of outstanding IRS and private sector and foreign banks, with about 19%, and 7%, of total bank assets, accounted for 18%, and 80%, of total notional principal amount of outstanding IRS, respectively. In other words, with combined assets of just Rs. 6 trillion or so, foreign banks accounted for notional principal amount of outstanding IRS of Rs. 40 trillion. He further emphasized on the fact that the IRS yields trade below yields of comparable maturity government securities. Specifically, currently the 5 year IRS yield is trading at a negative spread of 120 basis points to 5 year G- Sec. Besides, while the G-Sec yield curve is almost flat, the IRS yield is steeply inverted to the extent of 120 bps defying term, credit risk and liquidity risk premia which typically characterize a normal yield curve of risk assets. He cited a rationalization typically offered for this preposterous feature was that while IRS yields are influenced by expected path of future interest rates, those of G-Secs are influenced by their supply, deeming it fallacious because, being pure time value of money, G-Secs are influenced by and immediately price in, inflationary expectations arising from higher fiscal deficit which, in turn, is the cause of additional supply of G-Secs and not the other way round. He thus expressed that we have an IRS market completely upside down and running on its head and was anti-thetical to the law of one price, or the no-arbitrage argument because if the Law of One price did in fact hold, then given hugely negative spreads to G-Secs, fixed rate receivers, who far exceed, fixed rate payers, would have engaged in a very simple arbitrage, involving buying corresponding maturity G-Sec in the cash market Keynote Address delivered by Mr. V.K. Sharma, Executive Director, Reserve Bank of India, at Finnoviti 2012 organised by Banking Frontiers, Mumbai, India, on November 8, The views expressed are those of the author and not of the Reserve Bank of India. 30

4 SPEECH by financing it in the overnight repo market, and paying fixed, and receiving overnight, in the IRS market which would be a win-win situation for all key stakeholders. He however noted that this was not happening and reiterated that a fallacious explanation made for such a counter- intuitive feature was because of the existence of a 'Basis Risk'. He however expressed that such a reason was untenable because that basis risk applies just as much to hedging as indeed it does to arbitrage i.e. it is arbitrage-hedging agnostic and thus reasoned that that the IRS market is also not being used even for hedging. Hence, he raised the question that when one considers the fact that only 2% of the notional principal amount of the outstanding IRS is accounted for by the real sector i.e. business customers, what then was 98% of this `50 trillion IRS market being used for. He thus stated that in the case of the Indian IRS market, what holds instead is the law-of-two-prices-and-no-arbitrageargument and instead of being a means to an end of sub serving the real sector, the IRS market is existing, almost entirely for its own sake to almost complete exclusion of the needs of the real sector, creating a massive financial sector-real sector imbalance naming it as a financial innovation that never was. Describing the Indian CDS market as a stillborn market, Shree V.K. Sharma opined that the epitaph of CDS was written in the warped, anomalous, quirky and preposterous feature of hugely negative IRS yield spreads to corresponding maturity G-Sec yields itself. Significantly, if actual CDS premium is higher than the above theoretical price, then an arbitrageur would sell a CDS and receive this actual spread and short the reference bond and invest the proceeds of short sale at the going corporate bond repo rate and receive fixed, and pay overnight, in an IRS, and do the opposite arbitrage if the actual CDS spread is lower than the theoretical price until the arbitrage opportunity disappears and theoretical and actual market prices align again. But this arbitrage is just not possible simply because of its complete absence in the IRS market. Emphasizing on the IRF market, Shree V.K. Sharma reiterated that Interest Rate Futures on 10-year notional government bond had seen two settlements viz. the December 2009 contract and March 2010 contract. Both these settlements were a far cry from the hall-mark and touch-stone of an efficient, frictionless, seamlessly coupled, and organically connected, physically-settled futures market even where physical delivery typically does not exceed 1% to 3% of the peak Open Interest. This happened because of the inefficient disconnect and friction in the IRF market due to only one way arbitrage. He however, cautioned against the introduction of cash-settled IRFs because any cash-settled derivative, where physical settlement is possible, tends to become a nonderivative, violating the cardinal principle of arbitrage-free pricing/valuation and, therefore, comes to exist almost entirely for its own sake and to almost complete exclusion of the larger public policy purpose of sub-serving the hedging needs of the real sector, creating a massive financial sectorreal sector imbalance and, thus, in turn, become the very antithesis of responsible financial innovation. He then attributed market segmentation as the main contributor to price distortion and inefficiency stating that the most tangible and manifest evidence of market segmentation in India is the dis-connect between IRS, IRF and G-sec markets. Shree V.K. Sharma concluded his speech by proposing measures for the development of a 31

5 seamlessly integrated financial market such as refraining from launching cash settled IRFs; refraining from permitting the most-liquid-singlebond IRF; disallowing the selling/repoing of securities acquired under market repo (rehypothecation); preventing the allocation of specific government securities to different primary dealers for market making as this would straight away fragment the market and lead to concentration of risk and militate against portfolio diversification; ensuring symmetrical and uniform accounting treatment of both cash and derivatives (IRF/IRS/CDS) markets and removal of the 'hedge effectiveness' criterion of 80% to 125% which militates against use of derivatives for hedging purposes for it is better to have 'ineffective' hedge than to have no hedge at all. He also suggested measures such as roll-back of the Held to Maturity protection i.e. substituting the current accounting hedge with derivative hedge; delivery-based shortselling in the cash market for a term co-terminus with that of the futures contract and introduction of term repo, and reverse repo markets, co-terminus again with the tenure of futures contract for borrowing and lending of cash & G-Secs and allowing actual notional/nominal amount of IRS/IRF on duration-weighted basis unlike the current regulation which restricts the maximum notional/nominal amount of hedging instrument to no more than the notional/principal amount of the exposure being hedged resulting in underhedging of risk. Source: 32

6 SPEECH International Monetary Policy Interactions: Challenges and Prospects Jaime Caruana Speaking on International Monetary Policy Interactions: Challenges and Prospects at CEMLA-SEACEN Conference 2012 (Uruguay), Jaime Cacuana said that a better understanding of monetary policy interactions is necessary to more systemic policy decisions because of longer period of its accommodation. He added that policy rates have fallen short of real growth by some measure and with some frequency for the world as a whole. Referring the relation between actual policy rates and output gap or inflation (T Taylor's Rule), he said that both, the steady-state real interest rate and potential output are exceedingly hard to measure. Hence keeping interest rates low for a prolonged period or the wide range of balance sheet measures large-scale bond purchases and liquidity supports do not always work out to address the inflation or output gap problems. During the global financial crisis, a very strong monetary policy response was seen as the right way to address the headwinds of the crisis. However post-crisis, the centre of gravity of the debate has been shifting towards a more preventive use of monetary policy to limit risk from the build-up of financial imbalances. All global outcomes reflect decisions of groups of policy makers in individual economies who take the decisions of policymakers in other economies as inputs to their decisions. And thus monetary policy decisions are outcomes of a dense web of interactions. First channel of policy interaction affects dynamics of exchange rate, assets prices as well as of capital flows. A reduction in the policy rate or the announcement that it will be kept low for some time should, all else equal, put downward pressure on the exchange rate. While the strength of the impact is not easily predictable, this is precisely one of the usual ways monetary policy is expected to operate. In addition, balance sheet policies can have a similar effect, as when central banks engage in large-scale bond purchases to push longer-term bond yields lower. There is considerable evidence that such operations have been quite successful in reducing yields. Second channel of interactions operates via government bond yields regardless of result of expectations of lower future policy rates or of direct bond purchases. It simply reflects the thorough integration of global bond markets. A third channel operates via other asset prices. The degree of market integration is also crucial. The effects are stronger for highly global markets, such as equities, and weaker for highly domestic ones, such as real estate. Other channels that operate via quantities are assets and liabilities denominated in foreign currency and capital controls. If interest rates are reduced in any of advanced economies, the emerging market borrowers find it cheaper to borrow in them and those who have already borrowed enjoy lower financing costs. Thus a substantial stock of foreign currency debt directly transmits the policy of the major central banks to other countries. And if local central banks raised rates, the borrowers prefer to borrow in external market because of increase in the cost of existing foreign currency loans. Capital flows are the other much-discussed channel. Easier Address by Jaime Caruana, General Manager, Bank for International Settlements To the CEMLA-SEACEN on November 16,

7 monetary conditions in core economies tend to encourage capital flows to economies where interest rates are higher. Consequently, it puts upwards pressure on exchange rates and on asset prices. The link between easier monetary conditions in core economies and capital flow surges is far from mechanical, and its strength varies greatly over time. Other factors which play a key role include changes in risk attitudes and domestic conditions. In response to an accommodative monetary policy, the central bank may seek a looser monetary policy to prevent a loss of trade competitiveness. Or alternatively seek tight monetary policy to prevent the financial stability and macroeconomic consequences of gross capital inflows which can help finance a build-up of financial imbalances. In both cases, doubts about the self-equilibrating behaviour of the exchange rate play a key role. More relevant effective exchange rate may exacerbate its link with monetary conditions in a specific country and potentially adds to the risk of instability through capital flows. The potential for withdrawal of cross-border credit has led authorities to build up war chests of foreign exchange reserves. And since damage can be done not only by the reversal of such flows but also by their preceding surge, authorities avoid large interest rate differentials, for fear of attracting capital inflows. Central banks' preferences for a looser monetary policy and resistance to exchange rate appreciation may pre-emptively take interest rates lower than they would otherwise or may intervene in foreign exchange markets and accumulate reserves in an effort to avoid reducing interest rates. Such central bank's behavior affects state of financial stability. These mechanisms have been at work both before the crisis and since. Before the financial crisis, there was massive increase in foreign exchange reserves, although it has slowed to a crawl in emerging markets in last one year. Thus keeping interest rates lower for suggested reasons is tough for EMEs and it is being exceedingly hard to set policy rates appropriately when they are so low in the larger economies. This makes EMEs central banks hard to deviate from their position. Thus a very accommodating monetary policy can become entrenched globally. Loose monetary policy conditions for long period can lead to macroeconomic problems in form of an inflation surprise or serious financial distress, when financial booms turn into busts. The common denominator of monetary authorities is an attempt to restrain the impact of foreign spillovers and of the induced policy response through interest rates and, possibly, foreign exchange intervention. He concluded his speech with suggesting three set of measures varying from standard monetary policy administrative tools (higher reserve requirements, and tight credit condition without encouraging capital inflows), macro-prudential tools (higher bank capital requirements, stricter and less cyclically loan loss reserves, and lower loan-to-value or debt-to-income ratios) and capital controls to smoothen monetary policy interactions and to design policy responses. He also said that both monetary policy and fiscal policy have to deliver their parts of jobs for increasing the effectiveness of policy decisions. Source: 34