By Jaspreet Kalra and Ira Dugal
MUMBAI, March 5 (Reuters) - The U.S. and Israel's attack on Iran is expected to weigh more on India's economic growth than its inflation, which will encourage the Reserve Bank of India to keep interest rates low, three sources familiar with policymakers' thinking and analysts said.
The conflict, which has rippled out across much of the Middle East, has pushed up oil prices by about 15%, disrupted gas flows from the region and triggered selloffs in Indian equity, debt
and currency markets, with the rupee hitting a record low and bond yields rising due to concerns about India's current account deficit and the risk of higher inflation.
Despite a weaker rupee and higher crude prices, the central bank is unlikely to take a hawkish turn, all three sources familiar with policy deliberations said.
Current assessments could change, one of the sources cautioned, in case of extreme developments in the Middle East.
The thinking of policymakers appears to have diverged from the market reaction.
Interest rates have risen in emerging and global markets since the Gulf conflict broke out. Traders in India's swap markets have added to bets on at least one rate increase over the next 12 months.
"I don't feel the market has sufficiently priced the risk from oil prices rising significantly and there could be room for swap rates to move even higher if Brent oil holds above $80 per barrel over the next couple of weeks," said Ritesh Bhusari, joint general manager for treasury at South Indian Bank.
The RBI's rate-setting panel, which meets for its next policy review in about a month, paused rate cuts at its last meeting in February after reducing the policy repo rate by 125 basis points in 2025.
The sources declined to be identified as they are not authorised to speak to the media. An email sent to the RBI on Wednesday seeking comment was not answered.
Conflict in the Middle East has muddied the picture for central bank policy projections globally. Traders have pushed back wagers on rate cuts by the Federal Reserve while adding to bets on a hike by the European Central Bank.
A rise in oil prices above $100 per barrel or a faster-than-expected pass-through of costs could run the risk of turning global monetary policy more hawkish, according to analysts at Goldman Sachs.
QUICKER HIT TO GROWTH
An immediate risk to India's growth comes from disruptions to gas supplies.
On Tuesday, Indian companies reduced natural gas supplies to industries in anticipation of tighter flows from the Middle East, a move that could hurt output in sectors including fertilisers and power.
If gas supply disruptions persist for more than four weeks, they could hurt economic growth for at least a quarter, one of the sources said.
If oil prices remained above $90 to $95 a barrel for three to four quarters in a row, the source said, India's expected 7%-plus economic growth in the next financial year would take a more sustained hit.
Under that scenario, growth could slow to about 6.5% from the current expectation for more than 7%, the person added.
Cuts in gas supplies to fertiliser and power companies could reduce output in those sectors in the near term, weighing on growth with a lag in the first and second quarters of the next fiscal year, a second source said.
“If oil prices remain high for an extended period, the ‘Goldilocks phase’ for the Indian economy will end,” the person added.
INFLATION BUFFERS
Inflation, meanwhile, is likely to rise more modestly in the near term.
Retail fuel prices in India have not moved in tandem with global crude prices, as fuel retailers often hold prices steady. The government can also cut excise duties to shield consumers if global prices remain elevated, the first source said.
“There is plenty of room on the inflation front,” the third source said. “If inflation were closer to 5%, there might have been a case for a pre-emptive hike, but it is currently near the lower end of the RBI’s tolerance band.”
India's retail inflation was at 2.75% in January, closer to the lower end of the RBI's 2% to 6% tolerance range.
A 10% to 20% rise in global oil prices could lift Indian inflation by 25 to 50 basis points if fully passed through to consumers, according to a Deutsche Bank estimate. With a partial pass-through, consumer price inflation could rise to the 4.5% to 5% range, it said.
“If the fiscal authorities keep retail pump prices unchanged, the RBI would be less worried about near-term inflation risks and focus more on downside growth risks,” Citigroup chief India economist Samiran Chakraborty said in a note this week.
“This could perversely make the policy stance less hawkish than what the immediate market reaction to higher oil prices might suggest,” he said.
However, the central bank may also be constrained from delivering more rate cuts if oil prices remain elevated.
“While the RBI is unlikely to hike rates, if inflation were to rise towards 5% due to higher oil prices, it would also be unlikely to cut rates to support growth in such a scenario,” Deutsche Bank chief India economist Kaushik Das said.
(Reporting by Jaspreet Kalra and Ira Dugal in Mumbai; Editing by Thomas Derpinghaus)
