By Rajesh Kumar Singh
NEW DELHI (Reuters) - India's headline inflation slowed to its lowest level in three years, hardening expectations for an interest rate cut by the central bank later this month to boost an economy that is set to post its slowest growth in a decade.
The wholesale price index (WPI), India's main inflation indicator, rose an annual 7.18 percent in December, the slowest since December 2009 and below analysts' forecast of 7.4 percent rise in a Reuters poll. Wholesale prices rose 7.24 percent in November.
The better-than-expected inflation data left most analysts debating not whether the Reserve Bank of India (RBI) would cut interest rates at its policy review on January 29, but by how much.
"The probability of a rate cut in January-end has increased," Abheek Barua, chief economist at HDFC Bank in New Delhi, said. "But the next question is whether it will be 25 basis points or higher."
Following the inflation data, financial markets rallied in anticipation of an early rate cut. India's 10-year bond yield fell to its lowest in 29 months. The rupee strengthened against the dollar, while swap rates fell.
The slowdown in the headline inflation was led by a moderation in the prices of fuel and manufactured goods. The annual reading for October was revised down to 7.32 percent from 7.45 percent, the government said in a release on Monday.
And a drop in non-manufacturing inflation, used by the RBI to gauge demand-driven price pressures, to 4.2 percent in December from 4.5 percent a month ago further bolstered hopes for the long-awaited cut.
Last month, amid mounting calls from politicians and industry for a lower borrowing rates, the RBI signalled a possible reduction in the January-March quarter.
The policy repo rate has remained unchanged at 8.0 percent since April 2012, putting India's interest rates among the highest of the major economies.
While a slowdown in the global economy has prompted many other central banks to support growth through monetary stimulus, the RBI has hitherto rebuffed calls for lower lending rates citing high inflation and the size of the fiscal deficit.
Economic growth that once looked poised to hit double-digits has been stuck below 6 percent for the past three quarters, hurt by a combination of weak investment and consumer demand.
(Read experts' views on December inflation data, click http://reut.rs/UjKFHx)
HIGHER CONSUMER PRICES
The slowdown has constrained job opportunities for a bulging young population, a worry for the Congress-led ruling alliance as it prepares for a series of state elections and a general election due in 2014.
It has also buffeted government revenues, swollen the fiscal deficit and put the country's investment-grade sovereign credit rating on the line.
Pilloried previously for his government's inaction as the economy lost steam, Prime Minister Manmohan Singh has launched a slew of bold measures since late last year.
Still, the economy is showing little signs of an upturn. Industrial output unexpectedly shrank in November, its fifth fall in the last eight months, and call for lower interest rates have grown louder.
Barua and several other economists, however, saw the RBI opting for caution deciding the scale of any cut, particularly as consumer prices were less encouraging.
Annual consumer price inflation accelerated to 10.56 percent in December on higher food prices from 9.90 percent a month ago.
Elevated retail inflation, a hike in rail passenger fares and a possible hike in fuel prices may limit the RBI's room for maneuver.
In a bid to mend its strained finances, the government last week hiked railway passenger fares after a gap of nine years and is studying a proposal to raise heavily subsidised fuel prices.
"We could see inflation below 7 percent by March, but the caveat is diesel prices," said A. Prasanna, economist at ICICI Securities, Primary Dealership, in Mumbai.
"At some point, the government has to raise diesel prices, as well as coal, and electricity prices. So, we see a scope for a total of 50 basis points cut in rates in January-March and then we expect a lengthy pause from the RBI."
(Additional reporting by Mumbai treasury and markets team; Editing by Simon Cameron-Moore)