Abstract
This study seeks to analyse the impact of Economic Policy Uncertainty (EPU) and Consumer Price Index (CPI) Inflation on the returns of the Nifty Financial Services Index in the period of March 2015 to December 2024. EPU is believed to have an impact on FSI returns via real options, real options via information/investor sentiment channels and real options via credit demand compression, risk pricing effects and portfolio reallocation effects. Monetary policy expectations are a mechanism that passes on the inflation signal of CPI inflation, with higher inflation under the RBI’s inflation targeting regime pushing up rate expectations, which subsequently squeezes net interest margins and increases equity discount rates. The monthly data for the period spanning major macroeconomic shocks including demonetization, the IL&FS crisis, the COVID 19 pandemic and RBI policy decisions were used for Ordinary Least Squares (OLS) estimates of mean return effects, Exponential Generalised Autoregressive Conditional Heteroskedasticity (EGARCH) estimation of asymmetric volatility dynamics and continuous wavelet coherence analysis. Mean FSI returns are difficult to explain by either EPU or CPI (R2 = 1.5- 1.8%) and neither variable has a direct influence on conditional variance in a linear model. Wavelet coherence analysis, however, shows that the co-movement of EPU-FSI increases in the medium to longer term (6-16 months) when policy crisis occurs. During inflationary periods, CPI-FSI co-movement focus is on a short to medium horizon (2-12 months). The results confirm that the time frequency dynamics is the primary mechanism of transmission and have clear implications for RBI forward guidance and horizon-specific portfolio management.
Keywords: CPI Inflation, Economic Policy Uncertainty, EGARCH Volatility, Financial Sector Returns, Nifty Financial Services Index, Wavelet Coherence.