WPI, Commodity prices and Information content

The stock markets across are taking a breather. Dow Jones ended the day yesterday with a mild red. Hang Seng trades slightly in green. Dollar index trades close to the important level of 90. The US 10 year trades around 1.65 up slightly from yesterday. The Dallas Fed President Robert Kaplan opined that the interest rates are expected to remain benign well into next year. The minutes of the last Fed meeting are slated to come out tomorrow and market expects them to aid the dovish sentiment. The news that there are some high level efforts to contain the geopolitical crisis in Middle east also will provide support to market (things are infinitely more complex than this).A speech delivered by the Fed Vice Chair Richard Clarida (transcript available on Federal reserve’s website) was a good read and provided an insight on how the financial markets across the world are connected and how the signalling quality of domestic yield curves has declined over a period of time. Interested readers should take some time out to read the speech. We will discuss this concept of signalling quality or information content in detail below.

Domestically, yesterday the WPI number was released for the month of April. Inflation as measured by the WPI rose to 10.49% in April compared to 7.39% in the previous month. This was its highest reading in 11 years. Whenever any news item is preceded with a screaming headline like a “decadal high” one would do well to look more closely. This is the first market dictum anything unique has more information content and hence has a greater potential to aid ourselves in formulating a bespoke strategy and response. If a monthly high or a yearly high is important, a decadal high is twice as important ( using a logarithmic scale !!).

So what we can infer from this. Against the WPI reading of 10.49%, we had seen the CPI reading at 4.29% published on 12th May. RBI targets the CPI inflation for its monetary policy purpose. But it was not the case always, lets check a bit of history here. In his book I do what I do, former RBI Governor Raghuram Rajan describes the tussle between choosing WPI and CPI indicator as a target metric in detail. The book is compendium of his speeches and in one speech delivered on 20th June 2016 he talks about this policy conundrum.

Rajan writes that historically (before CPI became the target and inflation targeting was taken up as a precise goal) RBI focused a lot on WPI. Theoretically this created two problems. WPI was not the inflation which the common citizen experienced, they experienced retail inflation more closely tied with CPI. The monetary policy success depends on how the inflation expectations are anchored hence to target something which was not the base for those expectations and consequent wage demands looked mildly incoherent. Rajan’s second argument and which is more relevant for us today is that the WPI contains lot of traded manufactured goods and commodity inputs whose prices is determined internationally. The domestic components of inflation such as education and health care services as well as retail margins which impact CPI are missing from WPI and hence make it less relevant for the common man. A central bank has little leverage in the context of commodity prices which are set internationally and a low WPI can lead them to delusionary thinking on their own efficacy.

One interesting point which he notes was that at that time WPI was way lesser than the CPI (falling commodity prices anyone!) and the industry felt that the targeting of CPI (high at that time) would lead to higher interest rates and hence a sizeable section was vocal in opposing this move. Readers would note that how the tables have turned now and the borrowers (even of industrial variety) are well served if CPI is targeted. Now lets come back to the information content of the decadal high reading. The bonds which move in accordance with the RBI policy mostly looked over this data. Commodity importers would already be witnessing the charts of copper and iron ore, so they wont glean much from the data. WPI is a delayed second order derivative of the price information which they already have. Hence we can safely conclude that the information content and hence its manifestation into action remains low for this data.