'The MPC is likely to prioritise the key mandate, which is inflation, while relying on other instruments to stabilise the currency and bond markets.'
The Monetary Policy Committee (MPC), the RBI's rate-setting panel, will start the three-day deliberations on Wednesday to decide on the interest rate. The decision will be announced on Friday.
The MPC kept the policy repo rate unchanged at 5.25 per cent in its previous two meetings.
The rupee this calendar year weakened 5.66 per cent against the dollar amid the West Asia conflict, which started late February.
The conflict resulted in a rise in crude-oil prices, and that can widen India's current-account deficit -- a key negative for the Indian unit.
On Tuesday, the rupee depreciated 0.29 per cent to settle at 95.27 per dollar, as against the previous close of 95 on the back of demand for the greenback among importers. The Indian unit has depreciated over 10 per cent in the past one year.
According to economists, the MPC is likely to maintain a separation between the monetary policy and exchange-rate management under its flexible inflation-targeting framework.
'The RBI is an orthodox inflation-targeting central bank,' Japanese brokerage Nomura said in a report.
'An interest rate defence of currency could lead to expectations of policy tightening whenever the rupee weakens, which would be a dangerous policy precedent,' the report added.
The report said the panel was expected to unanimously keep the repo rate unchanged, arguing that rate increases were an ineffective tool in defending a currency and that inflation had not yet become broadbased enough to warrant policy tightening.
Drawing parallels with the taper tantrum in 2013, Nomura said higher interest rates had limited success in supporting the rupee, while measures aimed at attracting foreign inflows proved more effective.
It expects the RBI to instead deploy non-monetary measures and macroprudential tools to manage pressures on the balance of payments and curb speculation against the currency.
Economists expect the central bank to stay focused on inflation despite pressure on the rupee.
"The MPC is likely to prioritise the key mandate, which is inflation, while relying on other instruments to stabilise the currency and bond markets," said Radhika Rao, senior economist and executive director, DBS Bank.
Rao said the headline inflation rate remained close to the midpoint of the RBI's 2 to 6 per cent target range while second-round effects from higher fuel prices were yet to emerge.
Economists expect the central bank to adopt a wait-and-watch approach while revising its inflation forecasts higher and maintaining rates at current levels.
They said that although the widening difference with the interest rate of the United States strengthened the argument for higher rates, currency management did not directly fall within the ambit of the monetary policy.
'One logic could be for the RBI to defend the currency by raising rates and attracting higher capital flows. However, currency management through rate action does not directly fall under the ambit of monetary policy,' Bank of Baroda said in a report.
It expects the RBI to maintain the status quo on rates and allow the rupee to find its own level while continuing intervention through spot and forward-market operations.
Emkay Global said the RBI was likely to reiterate the distinction between its monetary policy and foreign-exchange management at the June review.
'Any future rate hike would likely be aimed at curbing domestic demand pressures or anchoring inflation expectations, rather than defending the rupee,' the brokerage said, adding that foreign-exchange volatility would continue to be managed through reserves and regulatory measures.
Economists said the central bank was likely to acknowledge rising inflation risks from higher fuel prices, geopolitical uncertainties, and the possibility of an El Nino event. Most expect the RBI to raise its inflation projections for FY27 while retaining a cautious stance on rates.
While the case for policy tightening has strengthened since the April review, economists said rate action would likely be driven by broadbased inflation pressures and a rise in inflation expectations rather than weakness in the rupee.
Markets will also watch for any measures aimed at attracting dollar inflows, including steps related to external commercial borrowing, deposits of non-resident Indians, or other capital flow channels, economists said.
Feature Presentation: Mahipal Soni/Rediff
