The Reserve Bank of India is widely expected to make a modest cut in interest rates later on Tuesday to support an economy set for its slowest growth in a decade, with a deeper cut unlikely due to worries over the fiscal and external deficits and inflation.
A Reuters poll earlier this month showed most economists foresaw the RBI cutting its policy repo rate by 25 basis points to 7.75 percent in the policy review, and follow it up with a cumulative 75 bps of cuts by the end of September.
Since the last cut nine months ago, the Reserve Bank of India (RBI) has resisted pleas from businesses and politicians for further reductions.
But the central bank had held out hope of a cut sometime this quarter after Prime Minister Manmohan Singh's fractious coalition in September ended a debilitating phase of policy inaction to make urgently needed reforms to reduce the fiscal deficit and attract foreign investment.
The measures, which included giving foreign players more access to its retail and aviation sectors, helped India forestall the threat of a sovereign debt credit rating downgrade to junk status.
Recently, as part of an ongoing drive to trim spending, the government gave oil companies more room to set regulated diesel prices.
In December, inflation slowed to a three year low of 7.18 percent, further building expectations for a cut in rates.
Hopes of a large rate cut, however, were quashed after RBI Governor Duvvuri Subbarao said two weeks ago that inflation was still high, His comment pushed the benchmark 10-year bond yield up to 7.89 percent from a 29-month low of 7.79 percent touched after the soft December inflation number.
In a report on the economy, issued a day before its policy review, the RBI spoke of taking a measured approach to support growth while balancing the risks.
"Monetary policy needs to continue to be calibrated in addressing growth risks as inflation remains above the Reserve Bank's comfort level and macro economic risks from twin deficits persists," the report warned.
It said recent government reforms had staved off near term risks on the fiscal front, but sustained fiscal consolidation was needed to create room for monetary easing.
"Reforms in September 2012 have reduced immediate risks, but there is a long road ahead to bring about a sustainable turnaround for the Indian economy," the report said.
It also warned that widening current account deficit would also constrain chances to ease policy, even if inflation were to slow further.
The report went on to say that while inflation was likely to moderate in the current quarter ending in March, there were still significant risks posed to prices by suppressed inflation.
Looking ahead, the RBI will be calculating how much leeway it has left to ease once it sees the government's annual budget, due to be presented in late February by Finance Minister P. Chidambaram.
"The next step in monetary policy will be taken on the back of measures taken to back up the fiscal consolidation roadmap. A lot will ride on the budget," said Shubhada Rao, chief economist at Yes Bank in Mumbai.
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