India's central bank forecast to lower rates

It will view the moderation in core WPI as pointing to room to lower rates despite the rising headline inflation rate, says DBS.

DBS Group Research noted:

Inflation (Jun, today) is expected to register 7.6% (YoY), close to the 7.55% registered in May. In sequential terms, this works to a rise of 7% (MoM, saar) or 8% (3m/3m saar). Headline price pressures have picked up in recent months and upward revisions to backdated data have become a feature again.

March inflation, originally at 7.7% (YoY), could be revised higher to 8%. Rising food prices are mainly responsible for inflation creeping higher while core inflation has softened considerably in recent months. Manufacturing WPI ex-food, a proxy for core, has slowed to 2% (3m/3m saar) in May, the slowest since Sep10.

The year-on-year rate has eased to 4.8% in May from 5.9% average in Jan-Mar12 and 7.7% average in Jan-Dec11. The economy has slowed considerably in the meantime and GDP growth is probably running sub-potential with 2011/12 growth averaging 6.5%.

In our view, despite the rising headline inflation rate, the central bank will view the moderation in core WPI as pointing to room to lower rates. The weakening global economic backdrop and lower oil prices too moderate inflation concerns and strengthen the case for a rate cut.

As such, we are of the view that despite highlighting vigilance over resurgence of inflation at the last policy meeting, the central bank will lower rates by 25bps at the next meeting in end-July.

At the same time, inflation risks are not non-existent as noted by the central bank. The central bank would exercise particular caution in cutting rates henceforth given the sensitivity (albeit indirect and delayed) of the rupee to India's inflation differential with the rest of the world.

Given the trade linkages with the rest of the world, elevated inflation worsens the trade deficit (raises imports and lowers exports) and thus hurts the rupee. This can be ill afforded, and is likely to make central bank decision making more cautious than before.

We do not expect the policy repo rate to be lowered below 7.50% this year, which means interest rates drop by only 100bps this year, a small fraction of the rate hikes administered through the rate hiking cycle.