Inflation Drop Unlikely to Sway India's Hawkish Central Bank

(Bloomberg) -- A drop in India’s consumer price index to a record low is unlikely to impress a central bank that’s bracing for a pick up in growth and keen to burnish its inflation-fighting credentials.

Investors have cheered a near one percentage-point drop in the index, driving down sovereign bond yields by 7 basis points since the data was released on May 12. One-year swap rates have also fallen by more than three basis points amid expectations the Reserve Bank of India could adopt a less hawkish stance as early as its June 7 announcement.

Not so fast, say economists such as Radhika Rao at DBS Group in Singapore.

“A case is likely to be made for the RBI policy committee to return to an easing policy bias and cut rates," Rao said in a report. "But they are unlikely to oblige."

A normal monsoon is poised to boost rural incomes while increased government spending may also bolster activity in the $2 trillion economy in coming months. The bank’s monetary policy committee, having changed its stance to neutral from accommodative in February, will also likely be reluctant to reverse course so soon, especially when the Federal Reserve is likely to raise rates further.

The central bank will probably attribute the softer inflation to temporary base effects and cyclical trends, and focus on upside risks to prices in the second half of the year, Rao said.

Although headline inflation may come under target in the near term, the outlook for inflation called for "close vigilance" Governor Urjit Patel said, according to RBI minutes released on April 20. The central bank has said the economy will continue to recover from a sudden cash ban imposed late last year while salary increases for thousands of bureaucrats and the roll out of the goods and services tax, scheduled for July 1, could fan inflationary pressures.

Consumer prices rose 2.99 percent in April from a year earlier, down from 3.89 percent in March and below the 4.5 percent inflation rate the RBI forecast for April to September, dragged down by lower food prices. Over the medium term, the central bank aims to keep inflation around 4 percent and has said that core inflation -- which strips out volatile food and fuel costs -- has been sticky.

Rising Rupee

An almost 6 percent rise in the rupee this year is also driving down the cost of imports, but the central bank is probably more concerned about a deluge of liquidity in the banking system due to the cash ban.

Sonal Varma and Neha Saraf, economists at Nomura Holdings Inc. expect a rate increase next year as growth accelerates and inflation stays above target.

“We expect the RBI to move towards a tightening-policy bias towards end-2017 and hike repo rates by a cumulative 50 basis points in 2018,” the analysts wrote.

India is expected to grow at around 7.2 percent in 2017 and 7.7 percent in 2018, according to the International Monetary Fund, making it one of the fastest growing major economies.

“We believe that the RBI will acknowledge that current pressures on inflation
are turning out to be lower than expected; but in the same breath, the RBI is likely to continue sounding worried about inflation risks over the second half of the fiscal year to March 2018,” said Pranjul Bhandari, chief India economist at HSBC Holdings Plc.

Shailendra Jhingan, managing director and chief executive at ICICI Securities Primary Dealership Ltd., one of India’s biggest bond houses, said in an interview that the RBI is likely to keep benchmark rates unchanged in the fiscal year 2017-18, reducing the chances of a substantial move in bond yields.

To contact the reporter on this story: Anirban Nag in Mumbai at anag8@bloomberg.net.

To contact the editors responsible for this story: Ruth Pollard at rpollard2@bloomberg.net, Jacqueline Thorpe