Inflation tops forcast; yields up as RBI eyed

New Delhi: India's headline inflation unexpectedly accelerated in May, heightening expectations the Reserve Bank of India (RBI) would raise rates before its scheduled July review despite concerns over Europe's debt crisis.

The data came along with a sharp upward revision of March's reading and on the heels of April manufacturing output matching its fastest pace in 15 years, indicating strong growth and rising inflationary pressures in Asia's third-largest economy.

Separately, the finance ministry's chief economic adviser, Kaushik Basu, said the strong growth in manufacturing would continue and forecast the economy to grow 8.9 percent in the June quarter, topping the previous quarter's 8.6 percent expansion.

"This (inflation) increases the likelihood of an inter-meeting rate hike from the RBI (Reserve Bank of India) as inflationary pressures are really showing up," said Sebastien Barbe, the Hong Kong-based head of emerging markets research and strategy at Credit Agricole.

"It seems like the markets are also now less worried about the situation in Europe, so the RBI may be less reluctant to tighten before July."

Bond yields and overnight swaps rose on the data, while stocks trimmed gains. Analysts had earlier said the RBI would wait until its July 27 review to raise interest rates, seeing its hands stayed by Europe's woes and on liquidity tightness.

That view is now changing.

"RBI will increase the frequency of its baby steps and we expect some tightening measures in June itself and a repetition of those in the July policy," Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai, said.

"Baby steps" to normalise monetary policy is what the RBI has said is its preferred choice of action, but it has also kept open the option of a rate hike ahead of the July review to combat inflation which it deems "worrisome."

The wholesale price index (WPI) rose an annual 10.16 percent in May, higher than the median forecast for 9.56 percent in a Reuters' poll and April's 9.59 percent.

In a sign the May reading could be an underestimate, March inflation was revised to 11.04 percent from the earlier estimate of 9.90 percent. Recent WPI data have been similarly revised up.

India's economy grew at 7.4 percent in the year to end-March 2010 and is seen expanding at 8.5 percent in the current fiscal year that began on April 1.

Reforms more difficult

Persistently high inflation, which has been over the central bank's perceived comfort level of five percent for seven months running, could turn voters against the ruling Congress party before eight state elections scheduled in 2010 and 2011.

It would also dampen enthusiasm for reforms, such as a keenly awaited freeing up of retail fuel prices, crucial to improving public finances and stop state-run fuel retailers from bleeding.

The government deferred last week taking a decision on freeing fuel prices, worried about political opposition and the impact on prices.

Policymakers have repeatedly said inflation would ease on better prospects for crops from good monsoon rains. But a hike in fuel prices could push it up, an adviser has said.

On Monday, Basu said the impact would be limited.

"The inflation figure you are getting is going to go up," he said. "But if you go six months down the road... in my opinion you would see a smaller inflation then."

The benchmark 10-year bond yield, which had risen six basis points after the WPI data, ticked up another point to go past a five-week high of 7.68 percent.

"The hawkish comments by Basu led to a further sell off in an already nervous market," said Bekxy Kuriakose, head of fixed income at L&T Investment Management.

One-year indexed swap rates rose six basis points. The swap rate has risen over 50 basis points from a more-than 5-month low of 4.71 percent in early May on concerns over tight liquidity and expectations of higher policy rates.

Basu and Finance Secretary Ashok Chawla said the high WPI readings were a matter of concern, but inflation would soften in the months to come on cooling food prices.

Chawla forecast WPI to fall to 5-6 percent by December, with Basu adding it would be below 5 percent by end-March 2011.