RBI to stay on a wait & watch mode

We expect the Reserve Bank of India (RBI) to keep policy rates unchanged in the monetary policy review on April 1.

Consumer Price Index (CPI)-based inflation, or retail inflation, and Wholesale Price Index (WPI)-based inflation have eased in the past few months led by normalisation of food prices, flattening of commodity prices, and new-found strength of the rupee. Core CPI-based inflation has also eased a tad, while growth remains anaemic.

We acknowledge some upside risks to inflation in March, arising out of weather-related spike in food prices, but we don't expect RBI to react immediately before analysing the March inflation data (to be released in mid-April) thoroughly.

Monetary conditions are tight in India, but not excessively so. The real policy rate (repo rate - retail inflation), for instance, has been the lowest in the past five years compared to other emerging market countries. Between 2009-2013, India's average real policy rate was (-)3.6 per cent, compared to 4.1 per cent in Brazil, 1.2 per cent in Indonesia, 0.2 per cent in Turkey and 0.5 per cent in South Africa. We think RBI's aim will be to achieve a positive real interest rate of around one per cent, which at the current policy rate (8 per cent repo rate) would require average CPI-based inflation for 2014 to be around seven per cent (down from 10.1 per cent average in 2013). If monsoon turns out to be normal this year, then achieving a seven per centy average CPI-based inflation rate should not be onerous, in our view, especially given the favourable base effect expected to kick in during the second half of the year.

RBI's recent transition to a CPI-based monetary policy will keep interest rates higher for longer than previously dictated by the central bank's reaction function. If inflation comes down over time, rates will decline, but in the first few years of the new regime chances are rates will be sticky, with major rate cuts quite unlikely.

The writer is India Economist, Deutsche Bank AG