Inflation in India could worsen to 7.4%

Pressure to reduce subsidies and a weakening rupee are furthering inflation-related risks.

The weak industrial production will likely cause a 25bps cut in policy repo rates. Unless inflation comes in below expectations, the risk of a 50bps rate cut will increase. A total of 100bps of rate cuts is expected this year as inflation proves stubborn.

Here's more from DBS Group Research:

WPI inflation could rise to 7.4% from 7.2% in April and 7% average in Jan-Apr, but this hides a temporary sequential moderation in price pressures, especially primary and fuel price pressures. In sequential terms, primary and fuel prices are expected to remain unchanged and manufacturing goods prices, a proxy for core, is expected to expand at a trend 5% rate.

Nonetheless, headline price pressures are expected to resume even though the underlying or core inflation rate is modest in a weak growth environment. Inflation risks arise from the pressure to reduce subsidies and from the weakening rupee. PMI surveys corroborate this picture with output and input price pressures still strong.

Given the weak industrial production release, a 25bps cut in policy repo rates next week appear all but certain. Inflation will have to overshoot considerably such as above 8% to cause any rethink. Such overshoot appears unlikely given growth is weak and that will cap core inflationary pressures. On the other hand, if inflation comes in below expectations, the risk of a 50bps rate cut next week will increase. However, the view that aggressive rate cuts to spur growth might prove costly as they raise inflation beyond comfort level and renew and strengthen depreciation pressures on the rupee.

A total of 100bps of rate cuts is expected this year as inflation proves stubborn. This will not be sufficient to stimulate growth but neither can growth be stimulated by monetary policy without inflation rearing its ugly head. The expectation is for 2012/13 growth to slow further to 6.2% from 6.5% in 2011/12, much lower than current consensus for 7.6% growth.

Optimism is maintained on the currency than consensus and to see room for further trade-weighted exchange rate depreciation. Despite the growth slowdown, it is important for policymakers to tread cautiously with loosening monetary policy and to assess the extent to which the slowdown is driven by supply bottlenecks and an unfavourable business climate.