The Reserve Bank of India (RBI) is likely to keep its policy rate on hold this week, but could toughen its warnings against inflation, economists say, laying the ground for a hike in 2018 after prices accelerated at the fastest pace in 17 months.
The central bank has already been warning that inflation would return, ending a period of historically low levels that let it cut the repo rate by 2 percentage points to the current 6.0 percent over the past two years.
But the RBI, whose two-day policy review ends on Wednesday, is worried about higher global crude prices. Meanwhile, Prime Minister Narendra Modi's government, facing elections by 2019, last week unveiled an annual budget that will boost investment in the rural sector and introduce a major health insurance programme.
But how far the RBI is willing to go raises some market fears that it could switch to a tightening bias from its current neutral one - which would discomfort investors and the government.
"We expect the Monetary Policy Committee to tilt towards a hawkish tone from its neutral tone following higher fiscal targets, oil price increases and higher minimum support prices for crops," said Radhika Rao, economist at DBS Bank in Singapore.
The RBI has held rates steady since a 25 basis point cut in August. But prospects of a rate hike have increased as annual inflation accelerated to 5.21 per cent in December, breaching the central bank's medium-term target of 4 percent for a second consecutive month.
Most analysts expect the inflation rate to go higher, especially after the government promised farmers to buy their crops at 1.5 times the cost of production as part of its budget, and as crude prices continue to advance.
At 6.0 percent, the repo rate is at the lowest since November 2010 and the RBI has also worried about destabilising foreign outflows as global central banks such as the U.S. Federal Reserve raise interest rates.
Nonetheless, the RBI will need to tread carefully, given the prospect that any premature tightening move could throttle an economy expected to grow 6.7 percent in the fiscal year that ends March 31 - the slowest pace in about three years.
Any move towards higher rates is hence unlikely to bode well with executives and government officials, especially as the economy is finally showing signs of recovery.
Benchmark 10-year bond yields have risen more than 80 bps since July, the biggest move since the 2013 rupee crisis, due in large part to worries about a more hawkish RBI.
The RBI's focus on a 4 percent target for price increases has also been controversial. Some economists view it as an excessively tough interpretation of the central bank's inflation mandate, currently set at 4 percent but with an "upper tolerance level" of 6 percent and a "lower tolerance level" of 2 percent.
The target was unveiled as part reforms intended to bring more stability to monetary policy in a country with a history of volatile double-digit inflation.