Reserve bank of India may increase the interest rate to cool down Inflation

India's central bank may raise interest rates for the third time in less than two months to combat inflation running at a 13-year high.

The Reserve Bank of India will increase the benchmark repurchase rate to 8.75 percent from 8.5 percent, according to 16 of 22 economists in a Bloomberg News survey. The bank, which will release its quarterly monetary policy tomorrow at noon in Mumbai, will also raise the cash reserve ratio to 9 percent from 8.75 percent, 10 of 21 economists said.

Governor Yaga Venugopal Reddy, whose term at the Reserve Bank ends in September, is intensifying efforts to cool inflation that has accelerated to more than double his goal. Prime Minister Manmohan Singh, fresh from winning last week's confidence vote, is looking to Reddy to spearhead the fight against rising prices as he prepares for elections before May.

``We expect another rate hike,'' said Krishnamoorthy Ramanathan, who manages $1.9 billion in Indian debt at ING Investment Management Pvt. in Mumbai. ``The government has exhausted fiscal measures and hence is relying on monetary policy to bring inflation under control.''
India's key wholesale price inflation has accelerated to 11.89 percent even as the government cut import duties on edible oils, steel products and gasoline, foregoing revenue. The government also banned the export of corn, pulses, rice, wheat and edible oil to spur local supplies.

Standard & Poor's said this month that India's BBB- credit rating, the lowest level in the investment grade, may be cut to junk if faster inflation and higher government spending ahead of the election widens the budget deficit.

`Fiscal Headroom'
``The fiscal headroom available to relieve the inflation stress is fast reducing,'' said Shuchita Mehta, senior economist at Standard Chartered Bank in Mumbai. ``A higher budget deficit not only will crowd out private investment, but also is likely to be inflationary.''

Reddy, who has been tightening monetary policy since 2004, was caught wrong-footed as inflation in India surged in the past two months after the government was forced to increase energy prices by as much as 17 percent to cut losses at refiners.

Since June, Reddy has raised rates by 75 basis points and the cash reserve ratio by half a percentage point. The governor is trying to discourage lending from banks that could stoke consumer demand and add to inflation fanned mainly by higher prices of oil. Money supply is growing at about 21 percent, more than the central bank's 17 percent target.

Faster inflation is prompting other Asian central banks to also increase interest rates. The Philippine central bank has raised rates at its last two meetings, while Bank Indonesia has boosted borrowing costs for three straight months.

Weaker Rupee
Reddy has also had to contend with a weakening rupee this year, which has pushed up the cost of imported goods.

India's $912 billion economy may grow as little as 8 percent this year, Reddy estimates. The rupee has weakened 8.3 percent and the benchmark stock index fell by a third since January. The yield on India's benchmark 10-year bonds has gained 91 basis points this year on inflation expectations.

Prime Minister Singh extended his four-year tenure last week by proving his majority in parliament after his main ally, the communist parties, withdrew support on opposition to a nuclear energy accord pursued by the government with the U.S.
By averting early elections, Singh, who has suffered electoral reverses in nine of the past 11 state polls, has won more time to gain control over inflation.

Oil Prices
Singh may succeed in reining in inflation before the national elections if oil prices, which have dropped 13 percent in the past two weeks, sustain their downward trend. India imports 70 percent of its oil requirement.

Lehman Brothers Holdings Inc. expects India's inflation rate to start falling ``decisively'' from January, based on their assumption that growth will slow to 7.3 percent this year and the price of oil drops to $90 a barrel in the first quarter of 2009.

``Our inflation pulse measure is starting to turn, but pressure on producers to pass on input costs remain heavy,'' said Sonal Varma, a Mumbai-based economist at Lehman. ``A rate hike will help anchor inflation expectations.''