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NEW DELHI/MUMBAI (Reuters) - India's new, growth-seeking government and the inflation-focused RBI appear to have joined ranks to bolster the economy, but relations could face a big test should El Nino send food prices sharply higher and raise the odds of a rate hike.
With the monsoon set to start in the country this week, the Meteorological Department has placed the odds of El Nino - which can affect wind patterns and trigger both floods and sharply reduced rains - at 60 percent.
The government has stockpiled staples such as rice, wheat and sugar from bumper harvests in the last few years but it has limited means to control a jump in costs of fruits and vegetables that have the largest impact on food inflation in India.
That leaves the door open to rate increases as perhaps the only option should any surge in food prices imperil Reserve Bank of India (RBI) Governor Raghuram Rajan's aim to bring consumer inflation down to 8 percent by January.
The central bank kept its policy rate on hold on Tuesday, as widely expected, but eased rules to spur bank lending.
"If the impact of El Nino is significant and pre-emptive measures by the government prove inadequate, then the RBI might hike rates to contain inflationary expectations," said Radhika Rao, an economist with DBS Bank in Singapore.
"The impact could become more apparent in the second half of the fiscal year, so action can be expected by late December or in the March quarter."
RBI also soothed bond investors on Tuesday by tempering its inflation rhetoric and saying rates would remain on hold should inflationary pressures continue to ease, in a conciliatory move to the new government led by Prime Minister Narendra Modi.
The dovish tone raised expectations the central bank could even cut interest rates later this year, after increasing them by three-quarters of a percentage point since September. Benchmark 10-year bond yields fell to as low as 8.57 percent on Wednesday, its lowest level since Jan. 21.
The government is monitoring food prices and has said it can ease some of the price pressures from El Nino by releasing stockpiled food.
"The plan is to keep a close watch on movements in prices and ensure adequate food supply," said an official who attended a meeting last month among senior bureaucrats to review India's preparedness to deal with the impact of a weak monsoon.
Yet, the effectiveness of releasing more grain is doubtful.
Headline retail inflation averaged around 10 percent last year, partly due to a 41 percent annual jump in prices of vegetables such as onions and tomatoes that are widely used in Indian cooking.
Curbing prices of these staples is especially difficult since they are caused by structural problems such as insufficient cold storage capacity and poor roads that offer no easy solutions - as the Congress party found out last year when it was unable to prevent surging inflation.
In 2009, when India faced its worst drought since 1969, 10-year bond yields surged 130 bps from June 2009 to March 2010, forcing the RBI led by then Governor Duvvuri Subbarao to raise rates in March to contain high prices.
A bad monsoon could also impact production of oilseeds and pulses to bridge shortfalls in the domestic market. India is already the biggest importer of oilseeds with rising global prices leading to imported inflation.
"For this summer, inflation will still be driven to a large extent by the weather," HSBC said in a note on Tuesday after the RBI's monetary policy.
"Another hike isn't off the table," they warned.
Editing by Rafael Nam and Jacqueline Wong