RBI may hold key rates as inflation eases

Some economists expect inflation to bounce back in the next few months.

The Reserve Bank of India (RBI) is likely, economists say, to keep key rates as they are during the mid-quarter review of its monetary policy, scheduled Thursday, as the inflation rate continues to come down.

If it does indeed press a pause button, it will be the first policy review since January when a rate rise will not happen. It has raised the repo rate by 1.5 per cent to 6.25 per cent and the reverse repo rate by two per cent since January.

Headline inflation, as measured by the Wholesale Price Index (WPI), moderated to a 11-month low of 7.48 per cent in November, as compared to 8.58 per cent in October. The rate was 4.5 per cent during the corresponding period last year. The fall has mainly been due to the deceleration in food inflation during the month and the high base effect.

“The recent moderation in WPI inflation gives RBI room to take a breather before reassessing its monetary stance,” said Anubhuti Sahay, economist at Standard Chartered Bank, in a research note.

During the second quarter review of the annual policy in early November, RBI Governor D Subbarao assigned a “relatively low” probability to rate action for the next three months.

Analysts expect inflation to come down further but it may stay above the central bank’s comfort zone. “Inflation is on a declining trend as expected, largely led by softening of food articles’ inflation, although non-food articles show some stickiness. Overall, the softening trajectory could mean that inflation is 6-6.5 per cent by March 2011. We expect RBI to maintain a pause in the near term, given significant tightness in liquidity,” said Nischal Maheshwari, head of research at Edelweiss Securities. RBI had projected 5.5 per cent inflation by March 2011.

According to analysts, the tight liquidity in the banking system also supports a status quo decision on policy rates. The liquidity deficit is much larger than RBI’s comfort level and is expected to come under further stress due to advance tax outflows.

“Any further increase in policy rates at this point could exacerbate the strain. Also, with the recent drop in WPI inflation to 7.48 per cent, real rates have turned positive. The 10-year paper yield is at 8.1 per cent, and deposit rates in the range of 7-8 per cent weaken the argument in favour of further rate rises, to address the issue of negative real interest rates, which has persisted for most of 2010,” said Sahay.

Though inflation may come down in the medium term, economists are warning of re-emergence of price pressure. According to a Nomura Securities report, global prices of commodities such as sugar, cotton and non-ferrous metal continue to rise. In India, while headline food inflation is falling due to base effects, the extent of the seasonal decline has not yet played out due to unseasonal rains. In addition, a domestic petrol and diesel price rise seems likely.

“Overall, we see a tug-of-war between base effects that are positive for lower headline inflation over the next few months and underlying price pressures, which are starting to climb,” said Sonal Verma, India economist of Nomura Securities.

Verma expects WPI inflation to bottom out in the first quarter of 2010-11 at around 6.5 per cent and to start to climb to above 7.5 per cent in the second half of the year.

“We expect inflation to persistently exceed the RBI comfort zone of 5-5.5 per cent,” Verma added.