Food inflation accelerates, Reserve Bank action likely

The Reserve Bank of India (RBI) appeared ready to tighten monetary policy on Friday as accelerating food price inflation and street protests highlighted the risks of price pressures in the broader economy.

On Friday, the Reserve Bank of India (RBI) is expected to increase banks' reserve requirements but leave interest rates unchanged at its quarterly policy review, reflecting its dilemma of checking inflation while keeping economic recovery on track.

The RBI said on Thursday ahead of its review that high food prices could drive up prices in other sectors of the economy and warned a surge in capital inflows along with high domestic liquidity levels may also push up prices.

Bond yields briefly rose by 2 basis points following the RBI's warning on inflation but soon retreated. The Indian overnight indexed swaps market, meanwhile, appeared to rule out any rate rise on Friday.

Thousands of people stoned trains and blocked roads in Bihar, one of India's poorest states, to protest high food prices in a sign the Congress-led government could face political fallout if prices fail to ease.

Despite political worries, the government has pressured the RBI to keep monetary policy loose, worried any tightening could choke off recovery just as credit growth and industrial output rise. Officials say food inflation should taper off by March.

Still, with actual bank lending rates well above policy rates, whatever the RBI does is likely to be less important than what it says as it retreats from crisis-level policy settings. 

"All that matters is the bark, the signal, because there's no real teeth to a policy tightening at this stage anyway," Philip Wyatt, an economist with UBS in Hong Kong, wrote in a note.

Economic recovery in Asia has led to inflation resurfacing across the region and some central banks, including in China and the Philippines, have taken steps to unwind ultra-loose monetary policy.

In India, markets expect a 50-basis point rise in banks' cash reserve ratio (CRR) , the proportion of deposits lenders must keep with the central bank in cash.

The food price index rose 17.4 per cent in the 12 months to Jan 16, accelerating for the first time in four weeks. The index rose 0.4 per cent from a week earlier. The fuel index rose to an annual 5.7 per cent, below a rise to 6.3 per cent the previous week.

Many expect the wholesale price index, which was 7.3 per cent in November, to touch double digits by March, and most analysts see rate rises later in the year.

"The RBI could further indicate that in the medium term, should credit growth rise faster than is currently indicated, then the pace of tightening would need to be adjusted," said Rahul Bajoria, an economist with Barclays Capital in Singapore.

In India, growth in bank loans, also a barometer for private investment in the economy, is sluggish but improving. Bank loans grew an annual 13.7 per cent as of Jan 1 compared with the RBI's forecast of 18 percent for the current fiscal year ending March. 

Indian banks have been saddled with costly deposits they cannot lend as credit demand remains sluggish.

Players in the Indian overnight indexed swaps market  ruled out a rise in central bank interest rates at the quarterly policy review, leaving the market prone to a spike in rates if it surprises with such a move.

With one-year OIS rates at 4.85 percent and just 10 basis points above the current repo rate, the swap market is not pricing in any move higher in interest rates until April at the earliest. 

The debt markets have already priced in a 25-50 basis point increase in the CRR and dealers expect bond prices to rally and yields to touch 7.45 per cent if the RBI hikes only the CRR and keeps interest rates unchanged.

The yield on the benchmark 10-year bond rose slightly on Thursday after the central bank raised concerns on inflation in its review of the economy, before retreating.

A Reuters poll last week showed 24 out of 25 economists expected the RBI to raise the CRR by up to 50 basis points at the meeting.                                             India's economy is expected to expand at 7 per cent in the current fiscal year to end-March, faster than 6.7 per cent last year, helped by a recovering global economy and rapid expansion in domestic industrial output, a Reuters poll showed.

The economy grew 7.9 per cent in the quarter through September, its fastest in 18 months, while industrial production grew in November at its fastest pace in more than two years at 11.7 per cent. 

That growth, however, has largely been fuelled by government stimulus spending and cheap credit following policy rate cuts totaling 425 basis points between October 2008 and April 2009.