FACTORS AFFECTING INTEREST RATES IN DEBT MARKET

Impact of Inflation Indices:

In economics Inflation means, a rise in general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Thus, inflation results in loss of value of money. Another popular way of looking at inflation is "too much money chasing too few goods"

CPI(Urban) and CPI(Rural) are new indices in the group of Consumer price index and has a wider coverage of population. This index compiled by Central Statistical Organisation tries to encompass the entire population and is likely to replace all the other indices presently compiled.

Factors affecting inflation: 

Food articles inflation

Inflation in food articles is one of the main drivers of the WPI inflation. In India, agriculture sector is mostly dependent on the monsoon; if monsoon is adequate then it improves food production which results in softening of food inflation. Therefore, the monsoon is an important factor.

Weightages of food in WPI is 15.25% and CPI is 49.71%.

                                                                       WPI

CPI

*Source: RBI

Global commodity and crude prices 

As many of the commodities and large portion of crude is imported in India. Therefore higher prices of crude and commodities abroad will have a cascading effect on domestic commodity prices, and hence result in higher inflation.

Weightages of commodities in WPI is 14.83%. Weightages of Fuel & Power in WPI is 13.15% and CPI is 9.49%.

WPI

CPI

*Source : RBI

Liquidity and interest rates 

High liquidity and higher disposable incomes are other factors that would keep the inflation rate high in the economy. The spending on the government's fiscal stimulus packages and fund inflows from foreign institutional investors (FIIs) can result in a surge in liquidity in the economy. The tax cuts will put more money in the hands of consumers.

Besides for a growth in money supply, inflation is also driven higher by low interest rates, because the excess money pushed by low interest into the economy drives prices up. Therefore, high inflation usually leads to the central bank raising interest rates, while lower than desired inflation rates can lead to lowering of interest rates.

Currency and Inflation 

The exchange rate determination is an important component for the inflationary pressures that arises in the India. Due to currency depreciation, the commodities are imported at a higher price impacting the price rise. Hence, the nominal exchange rate and the import inflation are measures that depict the competitiveness and challenges for the economy.

Just to give brief about impact of currency depreciation we can say that every 10% depreciation in Rupee impacts inflation by 0.9% to 1.0%.

Impact on Bond markets 

A rise in the inflation rate impacts Bond market sentiments. Higher inflation results in higher interest rates. This results into higher yield on the bonds. The price of fixed income securities is inversely proportional to the interest rate. Lower Interest rates will aid in fall of yields of fixed income securities. A fall in yields will push the bond prices higher and hence the NAVs of debt funds. When the interest rates increase the price of the fixed income security decreases and similarly when the interest rates are slashed, the price of the fixed income security increases.

Credit Rating

The yield a bond pays is dependent on the credit quality of the issuer. The credit rating indicates the ability to make timely interest and principal payments.

Ratings are letter grades, with AAA as the top rating, then moving down through AA, A, BBB and continuing the pattern to a single C or D (depending on the rating agency). Credit ratings of BBB or higher meet the definition of investment grade bonds. Bonds with lower ratings are considered to be noninvestment grade and are referred to as high-yield or junk bonds. The lower the credit rating, the higher the yield a bond will pay.

Monetary Policy and Inflation - Harder interest rates

Since monetary policies are influenced by inflation and inflationary expectations in the economy it is therefore, critical that inflation index should be able to predict future inflation with reasonable accuracy.

Generally, when a country is operating in a low interest rate regime, borrowers can borrow money at a lower interest rate. This aids in increased purchased power of the consumers. The demand for the goods increase and subsequently sensing a higher demand, the prices will also raise. This condition drives the inflation rates higher. When the inflation rates raise more than the optimal levels, the Reserve Bank of India (RBI) steps into increase interest rate to control inflation rate. When inflationary pressure starts building in the economy RBI hikes the repo rate and/or cash reserve ratio (CRR) to manage the money supply causing higher inflation.

Maintaining an optimal inflation rate is the primary task of Monetary Policy decision makers of any nation. An optimal inflation rate ensures a healthy economy. More often than not, the policy makers tend to spur growth in a stalled economy by slashing the interest rates, thereby increasing the money available in the markets. However, in order to implement such rate cuts the inflation rate should be at an optimal level. So, it becomes the prime responsibility of Reserve Bank to monitor Wholesale Price Index (WPI) and Consumer Price Index (CPI) to ensure that economy is balance.