Inflation eases; upside risk remains

A farmer carries a basket of tomatoes to load them on to a tractor trolley in the outskirts of Ahmedabad February 14, 2012.

NEW DELHI/MUMBAI (Reuters) - The government said on Monday that inflation had slightly eased in March, a day before what is forecast to be the first interest rate cut in three years, but a cautious tone from the Reserve Bank of India (RBI) added to expectations that monetary policy change will be gradual.

The wholesale price index (WPI), India's main inflation indicator, rose an annual 6.89 percent in March, higher than the 6.70 percent rise estimated by analysts, as manufacturing inflation eased even as food inflation shot up. But it was still below February's 6.95 percent reading.

The RBI said inflation was likely to remain near current levels during the fiscal year that started this month, with upward pressure persisting.

"While inflation has moderated, risks to inflation are still on the upside," the bank said in a report, a day before it is due to release its annual policy statement.

The central bank's nearly two-year battle against high inflation, coupled with a political logjam in New Delhi and an uncertain global economy, is expected to have slowed India's economic growth to a three-year low of 6.9 percent in the fiscal year that ended on March 31.

"A rising current account deficit, suppressed inflation and the structural nature of the fiscal deficit suggest that it will be a shallow rate cutting cycle," said Sonal Varma, an economist at Nomura in Mumbai, who expects a total of 75 basis points in policy repo rate cuts in 2012.

The RBI is widely expected to cut its main lending rate, the repo rate, by 25 basis points to 8.25 percent on Tuesday, though economists have been paring back their rate cut forecasts for the year amid worries about high commodity prices and a heavy fiscal deficit.

The RBI has already cut the cash reserve ratio, the share of deposits banks must maintain with the central bank, by 125 basis points in two moves since late January to 4.75 percent, making more money available for lending.

For a graphic on inflation click: link.reuters.com/deq95s

MIXED BAG

Manufacturing goods inflation, a barometer for demand-driven price pressures, dropped to 4.87 percent from 5.75 percent in February, giving solace to investors who have long sought a rate cut. However, the annual WPI reading for January was revised up to 6.89 percent from 6.55 percent, the government said.

Indian bonds and swap rates were little changed following the inflation data release, with traders pricing in a 25 basis point rate cut while looking ahead to the tone of the RBI Governor Duvvuri Subbarao's language.

The central bank's economic report was issued after the close of markets.

The 10-year benchmark bond yield ended down 2 basis points at 8.45 percent, after dropping by 22 basis points last week.

A spike in food prices and suppressed fuel inflation are expected to temper the extent of rate cuts for the year. Food inflation was 9.94 percent on year in March compared with 6.07 percent in the previous month, while fuel inflation eased to 10.41 percent from 12.83 percent in February.

"We expect RBI's statement to be slightly on the hawkish side, highlighting suppressed price pressures on inflation. But at the same time, the policy document will also highlight growth risks both domestically and globally," said Kumar Rachapudi, a fixed-income strategist at Barclays Capital in Singapore.

New Delhi is eventually expected to raise subsidised fuel prices in order to ease its fiscal burden, which would add to inflation. Domestic political obligations have helped keep fuel inflation mostly steady despite the rise in global oil prices in recent months.

However, India's heavy dependence on imported crude means a surge in global prices poses a risk to its finances if the government continues to absorb the increase instead of passing it along to end-users.

A weakened government, reluctant to make the politically unpopular move of raising pump prices, may do so soon to avoid digging a deeper fiscal hole after its deficit hit 5.9 percent of GDP in the just-ended fiscal year.

(Additional reporting by Archana Narayanan; Writing by Tony Munroe; Editing by Aradhana Aravindan and Andrew Osborn)