India's headline inflation slowed to its lowest level in more than two years in January as food prices fell, sparking hopes that the RBI will start cutting interest rates sooner rather than later to battle the country's economic slowdown.

Vendors
Vendors sell fruits at a weekly vegetable and fruit market in the northern Indian city of Chandigarh.

The wholesale price index, India's main gauge of inflation, rose 6.55 percent in January from a year earlier, its slowest rise since November 2009.

Tuesday's data, released by the government, was broadly in line with the 6.60 percent average forecast in a Reuters poll, after a rise of 7.47 percent in December.

Usually prices rise in January, but that has not happened to such an extent this time. The manufacturing and core manufacturing inflation have slowed down more than expected, said A. Prasanna, an economist at ICICI Securities Primary Dealership in Mumbai.

This has raised chances of a 25-basis point rate cut in March (rather) than in April. The rupee's rebound in January has also partially helped inflation to ease.

The Reserve Bank of India (RBI) is widely expected to start cutting interest rates in the quarter beginning April 1, as it looks to stimulate an economy that is headed for its slowest growth in three years.

The central bank ran a 20-month interest rate tightening cycle until October to slow down inflation to 7 percent by March. Economists expect the RBI, during 2012, to cut its policy rate by 100 basis points from the current 8.5 percent, with a cut of 50 basis points in the April-June quarter.

COMING FEDERAL BUDGET A KEY

Federal bond yields and swap rates fell after the January inflation data on hopes of an early rate cut.

This fall in core inflation bodes well to bring up the rate cut expectation, said Vivek Rajpal, an India strategist at Nomura in Mumbai. Our base case remains April cut, (but) market should from hereon start assigning some probability to March rate cut.

In keeping its policy rate unchanged last month, the RBI cited risks to inflation from global crude oil prices and the weak rupee, as well as India's yawning fiscal deficit.

The rupee fell nearly 16 percent last year against the dollar, before rebounding about 7.5 percent this year.

The fiscal deficit, however, is widely expected to be almost a percentage point higher than the government's target of 4.6 percent of gross domestic product for the fiscal year ending March 31, largely reflecting a slowdown in economic growth.

Despite growing odds for a March cut, the RBI might prefer to watch the mid-March budget before kick-starting the rate easing cycle in April, said Radhika Rao, an economist at Forecast Pte Ltd in Singapore. She expects the RBI to cut cash reserve requirements for banks at its March policy review.

The RBI cut cash reserve ratio for banks by 50 basis points to 5.50 percent at its last policy review in January. The next review is due on March 15, a day before the federal government presents the budget for the fiscal year that starts on April 1.

LOST MOMENTUM

The Indian economy has lost momentum as lingering euro zone debt woes coupled with high interest rates and a policy paralysis at home have hit capital investments.

The government last week cut the economic growth forecast for the current fiscal year to 6.9 percent, the slowest pace in three years. The GDP data for the October-December quarter is due on February 29.

If this (inflation) number stays soft going ahead and the GDP print also comes soft in February then together, there is a chance that RBI may cut rates in March (rather) than in April, said Siddhartha Sanyal, chief India economist at Barclays Capital.

Meanwhile, annual food prices in January fell 0.52 percent from 0.74 percent rise in December, helped by improved supplies of vegetables.

However, prices of protein-rich food items such as eggs, fish and meat, milk and pulses remained high, suggesting that food inflation remains a potential problem area.

Finance Minister Pranab Mukherjee said edible oils and milk are among items that may continue to threaten food inflation.

The minister, who said inflation remains unacceptably high said he expects it to keep moderating in coming months although softening in prices of manufactured goods may be more gradual. Mukherjee said he anticipates annual inflation to be closer to 6 percent at the end of March.

FUEL PRICE INFLATION

While manufacturing inflation dropped to 6.49 percent from 7.41 percent in December, non-food manufactured inflation -- a barometer for demand-driven price pressures -- eased to 6.7 percent in January from 7.7 percent a month ago.

Fuel prices rose 14.21 percent from a year earlier, compared with an annual rise of 14.91 percent in December.

Fuel inflation has been steady, as political considerations have forced the government to delay an adjustment in petroleum and coal prices.

Any government move to align domestic petroleum prices with global prices to reduce its massive subsidy bill runs the risk of igniting inflation.

A decision on petroleum subsidy reforms is expected after the conclusion of a series of state elections being held between now and early March.