RBI likely to cut interest rates despite inflation risk

India's worsening economic outlook as coronavirus cases soar has raised the chance the Reserve Bank of India (RBI) will cut interest rates at its policy review on Thursday, in spite of inflationary pressures.

Around two-thirds of economists in a Reuters poll expect the RBI to cut the repo rate by another 25 basis points (bps) on Aug. 6 to a record low of 3.50%, and once more next quarter.

"High inflation has added confusion to the Reserve Bank's policy outlook, but given the state of aggregate demand, we forecast the RBI will continue easing," said Rahul Bajoria, economist at Barclays who expects a 25-bp cut.

Annual retail inflation rose in June to 6.09% from 5.84% in March, remaining above the RBI's medium-term target range of 2%-6%.

The RBI's recent policies have focused on financial stability and the need to support growth despite the price target.

The country was placed under one of the strictest lockdowns in the world in late March for over two months to halt the spread of the coronavirus. The government gradually eased restrictions in June although infections continue to rise.

The poll showed most analysts expect the economy to contract 20% in the June quarter versus the April forecast of a 5.2% fall and remain in negative terrain until the December quarter.

For the full year 2020/21, the economy is likely to shrink 5.1%, which would be its weakest performance since 1979, a sharp contrast to the 1.5% expansion forecast in April.

Apart from rate cuts, Upasna Bharadwaj, economist at Kotak Mahindra Bank, expects liquidity and regulatory measures from the RBI to address demand shocks and financial market dislocations.

"RBI may look to widen the policy corridor to 75 bps by easing reverse repo by a higher quantum," she said, adding that though they expect a 25-bp rate cut, it may not be effective in the current environment.

The RBI has already reduced the repo rate by a total of 115 basis points since February, on top of the 135 basis points in an easing cycle last year, from 6.50%, responding to slowing growth.

Some economists, however, feel it may be prudent for the RBI to pause in August before resuming its rate-cutting cycle once inflation has stabilised.

Weakness in growth versus above-target inflation, improving indicators and concerns over inflation expectations will put the RBI in a tough spot, said DBS economist Radhika Rao.

"It will be a close call, but we see slightly higher odds for a pause."