Mid Quarter Monetary Policy and its impact

In keeping with the guidance and an increasingly benign stance, RBI reduced the repo rate by 25 bps to 7.50% in its monetary policy as of 19th March 2013. While doing so, it also emphasized that supporting growth is going to be a priority in days ahead. For RBI to achieve this outcome the revival of investments would be necessary; and thus the need for bringing down the cost of capital has become vital. However, the structural imbalance in demand and supply, along with the lagged impact of rising fuel prices may act as a limiting factor in repo rate moderation in the days ahead.

Inflation continues to moderate.
Inflation in WPI has been on a declining trend since Sep 2012 and stood at 6.8% for Feb-13. This was better than the expected figure and provides a headroom to the central banker.
The Core Inflation, which is inflation in non-food manufactured products, eased to 3.8% in Feb-13. This goes to higlight the demand-constraining effect of high interest rates on the core manufacting products. Growth Woes
The growth in the Indian economy has also moderated significantly during the period. GDP growth in Sept-Dec 12 was at around 4.5% yoy. In the last three quarter of FY13, the GDP growth was at around 5%. This is much below the potential of the Indian economy.
At that, the flat growth in the mining sector, and steep moderation in the agriculture and manufacturing sector highlight the structural imbalance that may have got built-in; and may require a prolonged redressal. Outlook
We remain largely optimistic with respect to the debt market for the following reasons:
The steep moderation in the economy, coupled with moderating inflation provides a robust grounding for implementing a repo rate cut in the future. The decline and de-growth in the manufacturing sector and mining sector makes it imperative that the investment cycle in the system be revived, lest the deflationary pressure sets in.
Already, the core inflation, which is inflation in non-food manufactured products, has come down to 3.8% in Feb-13. It is noteworthy here, that the monetary policy has a restraining impact mostly on the core inflation. (The inflation in the food and fuel segment is largely determined by demand supply interaction and is relatively less responsive to the policy rates). Therefore the impact of high interest rates seems to have been fully effected; and a policy reversal may be needed to support the manufacturing prices.
The gilt supply pressure in first half of FY14 is slated to be lesser than what it was in H1-FY13. In H1-FY14, the government is scheduled to borrow a net amount of Rs 2.7 trillion. For the market to absorb this supply smoothly, RBI may need to resort to OMO in the range of around Rs 600 bn during the period. This is expected to push down the gilt yields further.
However, the central banker remains circumspect about the risk which the large current account deficit poses to the economy. With current account deficit at around 5.4% of the GDP, India may need to discourage unproductive imports and also attract inflows on the capital account to meet the resource requirement.  For this purpose, RBI may need to maintain the high rates to attract foreign investments.
Also, the lagged effect of the fuel price; along with the upward pressure from the structural inflation may cause WPI inflation to remain sticky. This also restricts the headroom for RBI with regard to the monetary policy.
We continue to favor the fixed income investments across the maturity spectrums. The short term category provides a better risk reward profiling in the current market scenario. Actively managed duration funds also would be suited for investors who maintain a 1 year and beyond investment horizon.