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What nudged RBI to reduce policy rates?

Retail inflation (as measured by the Consumer Price Index) mellowed down further to 2.19% (an 18-month low) in December 2018 (data released in January 2019) from 2.33% registered in November 2018, well below the RBI's medium-term inflation target of 4.0%.

The fall in CPI inflation was mainly due to negative reading for food prices, and lower reading for 'fuel & light' and 'housing'. Perhaps weak consumer spending and rural distress were weighing on the inflation data, as both rural and urban inflation readings were low.

Lower CPI inflation reading stoked expectations of the central bank reducing policy rates, while a few others believed that at least the monetary policy stance would change from 'calibrated tightening' to 'neutral'.

But actually, the MPC pleased the market by doing both. All the members of the MPC unanimously decided in favour of a 'neutral' monetary policy stance, and 4 of the 6 members of the MPC voted in favour of a policy rate cut (the other 2 voted in favour of a status quo). This was done in consonance with the objective of achieving the medium-term target for CPI inflation of 4.00% within a band of +/- 2% while supporting growth.

The CPI inflation for January 2019 has mellowed down even further to 2.05%. Will RBI do more rate cuts?

Abetted by lower inflation reading for 'food & beverages', 'fuel & light', 'clothing & footwear', and 'household goods & services', the CPI inflation has eased to 2.05% (a 19-month low) in January (data released in February 2019).

Further, the CPI inflation reading was revised downward to 2.11% from the earlier estimate of 2.19%, as per the data released by the Ministry of Statistics and Program Implementation (MOSPI).

The core sector inflation reading appeared sticky, although the reading for January 2019 (data released in February 2019) came in at 5.36% v/s 5.66% in December 2018. However, core sector inflation, for now, has not been the guiding factor for RBI to reduce rates; it is the CPI inflation.

Cumulatively, CPI inflation for the period April 2018 to January 2019 is higher at 3.56% compared to 3.43% in the same period a year ago; however it is still below the RBI's medium-term target of 4.00% (within a band of +/- 2%).

Taking into consideration various developments on inflation, inflation expectation of households, outlook for crude oil prices, the effect of House Rent Allowance (HRA) increase for central government employees, and assuming a normal southwest monsoon in 2019,  the Reserve Bank has revised the path of CPI inflation downwards to 2.8% in Q4:2018-19, 3.2-3.4% in H1:2019-20 and 3.9% in Q3:2019-20, with risks broadly balanced around the central trajectory.

So, where are interest rates headed?

Data as on January 2019
(Source: MOSPI, RBI)

The central bank has projected headline inflation to remain soft in the near term, reflecting the current low level of inflation and the benign food inflation outlook. But beyond the near-term, the RBI is of the view some uncertainty warrants careful monitoring:

• First, vegetable prices have been volatile in the recent period; reversal in vegetable prices could impart upside risk to the food inflation trajectory.

• Second, the oil price outlook continues to be hazy. 

• Third, a further heightening of trade tensions and geopolitical uncertainties could also weigh on global growth prospects, dampening global demand, and softening global commodity prices, especially oil prices.

• Fourth, the unusual spike in the prices of health and education needs must be closely watched.

• Fifth, financial markets remain volatile.

• Sixth, the monsoon outcome is assumed to be normal; any spatial or temporal variation in rainfall may alter the food inflation outlook. 

• Finally, several proposals in the union budget for 2019-20 are likely to boost aggregate demand by raising disposable incomes, but the full effect of some of the measures is likely to materialise over a period of time.

In such times, policy rates could move either way, given the neutral monetary stance.

The RBI, in my view, would keep policy rates unchanged in its next, i.e. 1^st, bi-monthly monetary policy statement for 2019-20 (scheduled for April first week) and may wait until the outcome of Lok Sabha elections.

How should you approach debt mutual funds now?

(Image source: freepik.com)

In the aforesaid scenario, first, selecting the category of debt mutual funds becomes crucial. Investing aggressively at the longer end of the yield curve could prove imprudent, although the RBI has taken an accommodative stance.

Investing in long-term debt funds (holding longer maturity debt papers) can be risky in the foreseeable future. Currently, shorter maturity papers are more attractive, while you should pay attention to the quality of debt papers as well.

Ideally, you'll be better off if you deploy your hard-earned money in short-term debt funds; but ensure you're giving due importance to your investment time horizon, asset allocation, and diversification.

[Read: Asset Allocation: Hocus-Pocus Or The Essence Of Successful Investing?]

Consider investing in short-term debt funds for an investment horizon of up to 2 years.

If you have an investment horizon of 3-6 months, ultra-short duration funds would be the most suitable.

And if you have an extreme short-term time horizon (of less than 3 months), you would be better off investing in overnight funds. But avoid liquid funds that have a very high exposure to Commercial Papers (issued by private entities).

[Read: Why Your Money In Liquid Funds Is At Risk]

Don't forget that investing in debt funds is not risk-free.

A sensible and astute investment strategy paves the path to wealth creation and is always good for your long-term financial well-being.

Happy Investing!

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