By Murthy Nagarajan

The RBI governor would be announcing the monetary policy against a challenging economy background. There is considerable slack in the Indian economy as the economy has been operating below its potential capacity. The capacity utilization in the Indian economy is around 72 %, cyclical sectors like automobile at 55 % capacity utilization which has got reflected in the demand for basic, intermediate and final goods. The WPI has been negative from November 2014 onwards and the CPI inflation has moderated from July 2014 onwards due to fall in fuel prices and global food prices.

Indian GDP expected to be around 7 % for the last financial year. Due to unseasonal rains, rabi production of major crops has been lower than last year. Along with deficit monsoon of last year, the food grain production for the last financial year was at 251 million metric tons vs 265 million metric tons. In the current financial year, different variety of  Dal  have shown an increase of 10 to 30 %price increase  on a year on year basis as pulses production has be hit due to unseasonal rains. Banks have not been able to pass on the repo rate cuts to the borrowers, due to high level of NPA in the banking system. The total NPA along with restructured asset is around 6 Lakh crores which is 10 % of the total banking system loan book.

Global economy has still to recover in advanced economy even after quantitative easing by Europe and Japan, the US economy is the only country showing signs of turnaround in economic fortunes. New home sales in U.S have increased and the unemployment rates have come to 5.7 % vs 9.70 prevailing at the time of recession in 2008-09. The Federal Reserve is on course to increase interest rates in the September 2015 policy by 25 basis points. Already emerging markets have shown signs of weakness with the dollar strengthening against their local currency. Emerging markets including India have seen outflow of FII money from their local markets in the month of May 2015. This is getting reflected in falling stock markets and rising bond yields in emerging market countries.

Given this background, I expect RBI to cut rates by 25 basis points due to prevailing slack in the domestic economy but warn of the risks facing the Indian economy due to fed rates tightening and effect of poor monsoon on prices of agricultural commodities. RBI has maintained it wants 150 basis points to 200 basis points over expected CPI inflation. Given the CPI inflationary trajectory of 5.8 % by March 2016, the scope of further rate cuts in the coming months is limited. If these 25 basis points of rate cut happen in the June 2 policy, the next rate cut would be delayed to the next calendar year. The markets are expected to be choppy as the markets may initially rally but would tend to drift higher due to supply of government securities in the current financial year and absence of rate cuts in the near term. The increase in fuel prices and the effect of deficit monsoon would also led would led to CPI inflation drifting higher in the coming months. We expect the ten year Government security yields to trade in the range of 7.60- 7.75 % in the coming months.

(Murthy Nagarajan is the Head-Fixed Income with Quantum AMC)

(The views expressed in the column are solely of the columnist; Journospy is not liable for them)