Although since the 2nd quarter review of monetary policy 2012-13 (held on October 30, 2012), there has been uplift in sentiments in the global economy and there seems to be an indication of stabilisation, the situation yet remains fragile. The U.S. registered an increase in its third quarter GDP to 2.7% due to positive contribution from personal consumption expenditures (PCE), private inventory investment, federal government spending, residential fixed investment, and exports that were partly offset by negative contributions from non-residential fixed investment and state and local Government spending. Elevation in optimism in the U.S. after President Obama’s victory has pushed the Consumer Confidence Index in the U.S. to 73.7 (from 73.1 in October of 2012), while concerns over fiscal cliff yet remain. Speaking about the Euro zone, for Greece, the European Union (EU) and the International Monetary Fund (IMF) have agreed to unblock Greek bailout with a package of measures worth €40 billion, aimed at bringing an immediate 20% reduction to the country's debt. Likewise for Spanish bank loans, restructuring is approved (which would inject around €37 billion into the Euro zone); but the situation in the Euro zone yet remains delicate and it may not too long before fresh crisis in Europe could flare up. Apparently, the stronger Euro zone nations are facing the risk of downgrades. Last month, Moody’s stripped France’s credit rating to “AA1” from “AAA” and declared that the outlook remains negative. Germany too has seen a descending trend in the GDP growth rate for the last three quarters; which again indicates that even the stronger nations in the Euro zone are now reeling under pressure, and if we assess, the entire Euro zone it remains mired in a recession. As far as the Emerging and Developing Economies (EDEs) are concerned, while several of them are are gradually returning to higher growth, weak external demand and contagion risks from Developed Economies (DEs) render them vulnerable to further shocks.

Take the case of India, we have encountered descending trend in economic growth since the last fiscal year (i.e. FY 2011-12), although there seem to some signs of modest firming of activity the third quarter of the present fiscal year. The Index of Industrial Production (IIP) for the month of October 2012 (data released in November 2012), rose sharply supported by a low base effect and festive related demand (which propelled both consumer durable goods and non-consumer durable goods into double-digit growth).

  The Inflation bug mellows down

(Source: Office of the Economic Advisor, PersonalFN Research)

As far as the WPI inflation bug is concerned, it has mellowed down to 7.2% in November 2012 owing to softening of prices of vegetables, minerals and fuel. But protein based items are yet firming up. In striking contrast to wholesale inflation developments, retail inflation remained elevated. The new combined (rural and urban) Consumer Price Index (CPI) (Base:2010=100) inflation increased in November 2012, reflecting sustained food inflation pressures, particularly in respect of vegetables, cereals, pulses, oils and fats. The non-food component of the index also suggested persistent inflationary pressures.

As far as the liquidity situation is concerned, it has remained tight in the third quarter of the present fiscal year due to large Government balances with the Reserve Bank and the widening wedge between deposit and credit growth. But with a view to contain the liquidity deficit at reasonable levels, the central bank has conducted Open Market Operations (OMOs) on December 4 and 11, injecting primary liquidity of Rs 232 billion. Accordingly, money market rates remained close to the repo rate.

Monetary Policy Action…
Thus in the background of the aforementioned macroeconomic assessment, it was been decided by the Reserve Bank of India (RBI) to keep policy rates unchanged as under:
 

• Repo rate at 8.00%; and
   
• Reverse repo rate at 7.00%
   

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points. Also the Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate stands unchanged at 9.0%. Likewise the Bank Rate was also left untouched at 9.0%

Also since the OMO conducted in the recent past (on the aforementioned dates) have injected primary liquidity as mentioned above, the Cash Reserve Ratio (CRR) too was left unchanged at 4.25%.

  Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(50 bps)	8.00%
Reverse Repo Rate	(50 bps)	7.00%
Cash Reserve Ratio	(50 bps)	4.25%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI, PersonalFN Research)  

The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. Keeping it unchanged means, borrowing cost of commercial banks would remain unchanged. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may remain at the rates offered at present by them.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Keeping them unchanged will result in commercial banks fetching the same interest rate, as what they are receiving so far, for parking their surplus funds with RBI.

The Cash Reserve Ratio is the amount of liquid cash which the banks are supposed to maintain with RBI. Keeping it unchanged to last reduced level, would not infuse short-term liquidity in the system.

The Statutory Liquid Ratio (SLR) is the amount that the commercial banks require to maintain in the form of cash, or gold or Govt. approved securities before providing credit to the customers. Keeping it unchanged at the last reduced level of 23.00% could improve credit flow in the system – especially to productive sectors, and thereby support growth.

Guidance from monetary policy and path for interest rates:

The headline inflation has been below the Reserve Bank’s projected levels over the past two months. The decline in core inflation has also been comforting. These emerging patterns reinforce the likelihood of steady moderation in inflation going into 2013-14, though inflation may edge higher over the next two months. In view of inflation pressures ebbing, monetary policy has to increasingly shift focus and respond to the threats to growth from this point onwards. Liquidity conditions will be managed with a view to supporting growth as stated in the 2nd quarter review of monetary policy 2012-13, thereby preparing the ground for further shifting the policy stance to support growth. Overall, recent inflation patterns and projections provide a basis for reinforcing the October guidance about policy easing in the fourth quarter. However, risks to inflation remain and accordingly, even as the policy emphasis shifts towards growth; the policy stance will remain sensitive to these risks.

What should Debt fund investors do?

Looking at the growth-inflation dynamics, interest rates are likely to hover around at the present level, until distinct signs of moderation in WPI inflation are evident. We are of the view that the fourth quarter of this fiscal year - mostly from the 3rd quarter review of monetary policy (scheduled on January 29, 2013), the central bank may gradually start reducing rates, whereby by the fiscal year end 2012-13, we could witness 50 bps reduction in policy rates.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 month, or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers could become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an investment horizon of say 2 to 3 years. However, one may witness some volatility in the near term as there is always an interest rate risk associated with longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may for some more time yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced further. At present 1 year FDs are offering interest in the range of 7.50% - 9.00% p.a.

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