Low inflation gives India chance to cut rates, but window could close

By Swati Bhat and Rafael Nam

MUMBAI (Reuters) - A sharp fall in inflation has provided India with a window to cut interest rates for a third time this year, as the central bank prepares for a policy review on June 2.

"We are expecting a 25 basis point rate cut in June with a cautious tone, but not too hawkish," said Shubhada Rao, chief economist with Yes Bank, looking ahead to the policy review.

Wait any longer, and the start of monsoon rains and potential U.S. rate hikes could limit chances for the Reserve Bank of India to reduce the repo rate, currently at 7.50 percent after two quarter-percentage point cuts in January and in March.

Bonds and overnight index swaps have rallied on prospects for a rate cut after data last week showed consumer inflation at a four-month low of 4.87 percent in April and industrial output at a five-month low.

"All recent high frequency data point to a severe disinflationary trend in the country," said Rupa Rege Nitsure, chief economist at L&T Financial Services.

"There is no immediate threat from the rupee weakness either, so they have the opportunity of reducing rates until June. After that, there will be more uncertainties."

India will release gross domestic product data for the January-March quarter on Friday.

Although India's growth rate overtook China's in the October-December quarter, the economy is still in need of stimulus, as investment remains stubbornly low, and there are doubts over the reliability of data, after the statistics department changed its methodology earlier this year.

At the last policy review on April 7, the RBI expressed caution over the economy, noting "mixed signals" in the services sector and potential underlying weakness in consumption.

Low credit growth and weak capacity utilisation also point to an economy only in the early stages of recovery.

SECOND HALF CUTS RARE

RBI Governor Raghuram Rajan has shown willingness to act swiftly: each of the two rate cuts this year came outside of scheduled policy reviews.

Poor rains could cause sharp spikes in food prices. But, inflation - the main determinant of monetary policy, remains well within the RBI's 2-6 percent target range because of slumping oil prices.

If the RBI does choose to wait beyond next week's review to cut rates, it could be delayed until much later.

Since adopting the repo rate as a main tool for interest rate policy in 2004, the RBI has never cut interest rates during the monsoon rains season, running from mid-June to September.

During that time, the RBI has only cut later than May in one year, 2008, when it cut three times between October and December to counter the impact of the global financial crisis.

The main external risks this year are posed by potential market volatility once U.S. rates rise, and danger of some crisis developing should Greece fail to repay debt to the International Monetary Fund.

India, however, is a lot better place to withstand any buffeting from market turmoil, having amassed record foreign exchange reserves.

(Editing by Simon Cameron-Moore)