India's central bank is expected to keep interest rates unchanged for the second time in six weeks on Tuesday, with Governor Raghuram Rajan expected to strike a hawkish tone on inflation that is easing but remains high.
Investors are worried that rates will stay high for longer after a Reserve Bank of India (RBI) panel last week proposed revamping the way monetary policy is made, including using consumer prices as a benchmark for targeting inflation.
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The consumer price index (CPI) eased to a three-month low of 9.87 percent but remains well above the central bank's policy repo rate of 7.75 percent. The wholesale price index, long the RBI's main price barometer, slowed to 6.16 percent in December.
"The report has triggered expectations that interest rates will remain elevated for an elongated period of time," said Soumya Kanti Ghosh, chief economic adviser at State Bank of India.
While it is not clear when the RBI might adopt any of the proposed changes, some of which need legislative approval, 10-year bond yields have risen to more than 8.7 percent from 8.5 percent before the report.
Meanwhile, a sell-off in emerging market currencies on concerns that growth in China is slowing and that the U.S. Federal Reserve could further wind back its monetary stimulus when it announces its two-day meeting outcome on Wednesday may keep the Indian rupee under pressure.
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That, in turn, could compel the RBI to keep the policy rate elevated.
"Given that there will be a tendency of emerging markets to keep interest rates at an elevated level due to the pressure on currencies, that will also give the RBI a justification to keep rates at elevated levels," Ghosh of SBI said.
Rajan faces the daunting challenge of reviving an economy growing at a decade low of around 5 percent while battling persistently rising prices, much of which has been fueled by supply-side shortages beyond the control of monetary policy.
A Reuters poll conducted last week showed that 45 of 50 economists expect the repo rate to be kept unchanged at the meeting and held steady until September before being cut by 25 basis points in the last quarter.
The results of the poll were received before the RBI released its report on revamping monetary policy.
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"While we cannot rule out a rate hike on Tuesday as Governor Rajan has surprised at two of his three meetings so far, we believe the RBI is unlikely to hike," said Anubhuti Sahay, senior economist at Standard Chartered Bank.
The rupee fell for a third consecutive session on Monday, hitting 63.06 to the dollar, its weakest in more than two months, as emerging markets sold off with the Fed poised to further cut back its monetary stimulus this week.