NEW DELHI (Reuters) - India's headline inflation picked up for the first time in five months in February on higher food costs but another measure of price pressures cooled, sparking market speculation that the central bank may surprise with an interest rate cut on Thursday.
The wholesale price index, India's main gauge of inflation, edged up a faster-than-expected 6.95 percent from a year earlier in February after a spike in vegetable prices fanned food inflation. Wholesale prices had risen an annual 6.55 percent in January, the slowest in 26 months.
But non-food manufactured inflation, which the central bank uses to gauge demand-driven price pressures, slowed to a 14-month low of 5.8 percent from 6.7 percent in January.
"The key trend that needs to get captured is on core inflation...and that is something that should go as a positive for monetary policy," said Shubhada Rao, chief economist at Yes Bank in Mumbai.
"We still believe the RBI could look at a repo rate cut of 25 basis points tomorrow."
Weakening economic momentum as well as a softer policy stance adopted by central banks in the region is piling pressure on central bank Governor Duvvuri Subbarao to start cutting rates sooner than later.
Graphic on inflation: link.reuters.com/deq95s
BOOST TO RATE CUT HOPES
Federal bond yields and swap rates eased on hopes of a surprise interest rate cut on Thursday, when the Reserve Bank of India (RBI) reviews its policy.
"The market is building an increased chance of rate cut in March now than before as the manufacturing inflation print was benign," said Kumar Rachapudi, fixed-income strategist at Barclays Capital in Singapore.
The 10 year benchmark federal bond yield dropped 7 basis points after the data to the day's low of 8.28 percent. The five-year benchmark swap rate eased 5 basis points to 7.48 percent while the one-year swap rate fell 5 basis points to 8.05 percent.
India's economic growth faltered to a three-year low of 6.1 percent in the December-quarter as a political logjam and the central bank's hawkish policy against inflation hit investment.
The pace of economic expansion this fiscal year is forecast to dip below 7 percent for the first time in three years.
"We are sticking with the view that a 25 basis point repo rate reduction is (just about) the most likely outcome," Credit Suisse analysts wrote in a note after the data on Wednesday.
"It is worth stressing that GDP growth, at 6.1 percent in the December quarter of 2011, was well below any estimate of trend growth and hence disinflationary, while money and bank lending growth has also softened in recent months."
WAIT AND WATCH
The central bank's main lending rate -- repo rate --- is at a 3-year high of 8.5 percent. The RBI last week surprised markets by cutting the cash reserve requirements for banks.
Most economists expect rising global crude prices and the need for a clarity on the government's fiscal roadmap would prevent the RBI from cutting rates before the April-June quarter.
"I think the big risk going forward for inflation will be driven by the revision in the domestic fuel prices, and we do expect inflation to sustain around 7 percent until March," said Abheek Barua, chief economist at HDFC Bank in New Delhi.
"The broad balance is in favour of a rate cut, but I would think the RBI would wait until it gets a firm fix on the contours of the budget (on March 16)."
India's Finance Minister Pranab Mukherjee faces an arduous task of trimming the federal fiscal gap, when he presents the annual budget on Friday.
With the deficit poised to miss this fiscal year's original target of 4.6 percent of GDP by a wide margin, Mukherjee is expected to cut fuel subsidy and raise tax rates to contain the fiscal shortfall.
A decision to raise pump prices is fraught with political risks, and it will likely also accelerate inflation and temper the pace of rate cuts.
A 10 percent increase in domestic fuel prices could increase headline inflation by 100 basis points, estimates Deutsche Bank, which may constrain the RBI from cutting interest rates swiftly.
"If you take just the direct impact of global oil prices at current levels, then the headline inflation number could at least be 90-100 basis points higher," said Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai.
Fuel prices rose an annual 12.83 percent, slower than a 14.21 percent on year rise in January.
(Additional reporting by Arup Roychoudhury in New Delhi; Archana Narayanan and Neha Arora in Mumbai; Editing by Emily Kaiser and Ramya Venugopal)
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