India to hold firm on policy rate

This is despite attractive benefits from a 50-bps cut this month, said Moody's.

In a release, the Reserve Bank of India is expected to leave rates unchanged at its Tuesday monetary policy meeting, although the economy could benefit from lower borrowing costs. India is facing stagflation: The economy is slowing while inflation remains high. Interest rates have not moved since a cut in April, and Duvvuri Subbarao, the central bank governor, recently said inflation is still above the bank comfort level, signalling no change this month.

Here's more from Moody's:

Subbarao's hawkishness is justifiable; yet he was slow to hike rates through 2010 even as the economy grew strongly. This lack of consistency and sluggish response has damaged the RBI credibility, adding to the stagflation problem. We think the RBI should be more aggressive; a 50-basis point rate cut this month would help reignite demand and close the negative output gap. A cut is also unlikely to spark more inflation because prices are being driven primarily by rising input prices rather than excessive demand.

Recent data reveal a slight cooling in inflation and continued weak growth, leading bond markets to price in a one-in-three chance of a rate cut this week. But recent central bank rhetoric makes this unlikely; moreover, a below-average monsoon and a weak rupee will keep food and import prices rising smartly. Before the central bank can cut rates, we will need to see either more rain or better progress on economic reform such as scaling back fuel subsidies. None of these conditions is in view at the moment.

Even if the RBI decides to ease, it is likely to do so gradually, first reversing its rhetoric and possibly cutting the cash reserve ratio. We expect interest rates to remain on hold through 2012. It isn't the correct policy, but it seems the most likely at this stage.