Inflation down, yet further rate cut unlikely from RBI

Duvvuri Subbarao, India's central bank governor, may remain unmoved by Monday's pleasant surprise. Headline inflation for March, as measured by wholesale prices, was 5.96 per cent, the lowest reading in over three years.

It was also below market expectations. A Reuters poll showed the market had expected inflation to be about 6.4 per cent.

The March inflation data comes on the heels of a softening trend in the international price of crude, which eases pressure on the general price level in India. The Indian basket of crude on April 12 (Friday) was $101.35, lower than last month's average of $ 105.95.

But despite these positive developments on the inflation front, Subbarao may refrain from a third consecutive interest rate cut in 2013 when he announces the next monetary policy on May 3.

Two factors may hold him back.

The pattern of food inflation has been different in the last few months. It has increasingly been led by elevated prices of cereals such as wheat and rice - staples in an Indian family's food basket. Unlike last year, price levels of vegetables and protein items such as milk and eggs have seen a softening trend.

Cereal prices tend to be sticky as they have long production cycles. Sowing-to-harvesting runs over months, making quick reversals in price trends unlikely.

By the time Subbarao announces his next policy , meteorologists will be busy working out the first forecast for the south-west monsoon, the primary source of rainfall in India.

What if the monsoon disappoints? Given the elevated level of cereal inflation in India, 18.36 per cent in March, Subbarao may choose to wait a while longer before he touches interest rates again.

Food inflation tends to have a dominant influence on expectations of households and the Reserve Bank of India has been wary of its power to unhinge households' inflationary expectations.

Besides tackling the challenge posed by food inflation, the RBI needs to create a benign environment for foreign investors who may wish to invest in Indian debt. Crisil Research forecasts that India will need foreign inflows of $90-95 billion in 2013/14 to finance a current account deficit of about 4.5 per cent of gross domestic product.

The interest differential between India and other markets has to be attractive enough to draw foreign money into Indian debt.

Subbarao may choose to be cautious with interest rates, but he may well loosen monetary policy through a cut in the cash reserve ratio. The liquidity deficit in the system has not eased in April and the governor may have no choice but to infuse more liquidity into the system.