India's new, growth-seeking government and its inflation-focused central bank appear to have joined ranks to bolster the economy, but relations could face a big test should El Nino send food prices sharply higher and raise the odds of a rate hike.
With the monsoon set to start in the country this week, the Meteorological Department has placed the odds of El Nino - which can affect wind patterns and trigger both floods and sharply reduced rains - at 60 per cent.
The government has stockpiled staples such as rice, wheat and sugar from bumper harvests in the last few years but it has limited means to control a jump in costs of fruits and vegetables that have the largest impact on food inflation in India.
That leaves the door open to rate increases as perhaps the only option should any surge in food prices imperil Reserve Bank of India (RBI) Governor Raghuram Rajan's aim to bring consumer inflation down to 8 percent by January.
The central bank kept its policy rate on hold on Tuesday, as widely expected, but eased rules to spur bank lending.
"If the impact of El Nino is significant and pre-emptive measures by the government prove inadequate, then the RBI might hike rates to contain inflationary expectations," said Radhika Rao, an economist with DBS Bank in Singapore.
"The impact could become more apparent in the second half of the fiscal year, so action can be expected by late December or in the March quarter."
The central bank also soothed bond investors on Tuesday by tempering its inflation rhetoric and saying rates would remain on hold should inflationary pressures continue to ease, in a conciliatory move to the new government led by Prime Minister Narendra Modi.
The dovish tone raised expectations the central bank could even cut interest rates later this year, after increasing them by three-quarters of a percentage point since September. Benchmark 10-year bond yields fell to as low as 8.57 percent on Wednesday, its lowest level since Jan. 21.
The government is monitoring food prices and has said it can ease some of the price pressures from El Nino by releasing stockpiled food.
"The plan is to keep a close watch on movements in prices and ensure adequate food supply," said an official who attended a meeting last month among senior bureaucrats to review India's preparedness to deal with the impact of a weak