Central Banks

India's Rajan in tough spot as stagflation risk emerges

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With softening economic indicators and rising inflation, Reserve Bank of India (RBI) Governor Raghuram Rajan will be faced with a tough decision at the central bank's policy meeting on Wednesday.

According to economists, Rajan will prioritize tackling inflation by lifting the benchmark policy rate by 25 basis points to 8 percent – the third rate hike in as many meetings, reversing all of the rate reductions earlier in 2013.

"The data pose the now familiar dilemma for the central bank. While the direct effect of interest rate hikes on inflation is debatable, particularly when food prices are such an important driver, we very much doubt Dr. Rajan can be seen to be sitting on his hands at this stage," Robert Prior-Wandesforde, director of Asian economics research at Credit Suisse wrote in a recent note.

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Expect a hawkish stand from RBI: Pro
Expect a hawkish stand from RBI: Pro

"To do so, would be take risks with his inflation fighting credentials," he added.

Recent data such as industrial production – which contracted 1.8 percent year-on-year in October following a 2.0 percent rise in the previous month – have raised concerns over the country's growth outlook.

Concurrently, price pressures have reemerged, with the wholesale price index (WPI) climbing 7.5 percent in November, marking its highest rise since September 2012, compared with 7.0 percent in October, on surging vegetable prices. Consumer prices, meanwhile, rose at their fastest annual pace on record at 11.2 percent, from 10.1 percent in the previous month.

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Sonal Varma, India economist at Nomura, says with the focus shifting away from wholesale inflation to consumer inflation, the spike in the latter suggests an imminent rate hike. Varma expects a 25 basis point rate hike this week, followed by another in the first quarter of 2014 to 8.25 percent.

"Even as a reversal in vegetable prices should lower CPI [consumer price index] in coming months, we do not expect CPI inflation to fall below 9 percent on a sustained basis, so interest rates should remain higher for longer," she wrote in a note.

And the best Asian market for 2014 is....
And the best Asian market for 2014 is....

Dicey dynamics

India's inflation uptick has stoked concerns of stagflation - where accelerating inflation is not met by higher growth rates – in Asia's third largest economy.

"Indeed, the whiff of stagflation is in the air. India faces the worst of both worlds right now: a rapid increase in prices and a sharp deterioration in the economic outlook," said Nicholas Spiro, managing director of Spiro Sovereign Strategy.

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And, Spiro expects the economic environment to remain challenging with the much-anticipated general election just round the corner, in April-May 2014.

"Amid the 'Modi mania' that's gripping India, big doubts remain about the country's ability to undertake the fiscal and structural reforms required to deliver sustainable growth and put the economy on a much firmer footing," he said, referring to Narendra Modi, prime ministerial candidate of the opposition Bharatiya Janata party's (BJP) which gained considerable ground in the recent state elections.

—By CNBC's Ansuya Harjani; Follow her on Twitter: @Ansuya_H