BofAML said the Reserve Bank will continue with its fight against inflation and hike the repo rate at which it lends to the system by 0.25 per cent at the mid-quarter policy announcement on December 18.
"We believe that inflation is peaking but will abate only in second half of 2014. We expect WPI inflation to peak about the current 7 per cent and come off to 5 per cent levels in H22014 if the 2014 monsoon is normal," it said in a note.
Core WPI inflation should rule at relatively benign sub-5 per cent levels with a tight RBI policy dampening pricing power, BofAML said.
Since taking over in early September, Governor Raghuram Rajan has hiked rates twice with an eye on inflation, which quickened to 7 per cent in October.
"We expect the RBI to shift the money market to repo mode from MSF mode with a 0.25 per cent hike in the LAF policy rate on December 18," it said.
MSF (marginal standing facility) is the penal rate at which banks borrow from the RBI after exhausting their borrowing limits under the repo window. The difference between repo and MSF rates has been normalised at 1 per cent.
Inflation as measured by the consumer price index may come down to 8.5 per cent by March 2014 and 7.3 per cent in March 2015, the brokerage said. It was at 10.09 per cent in October.
BofAML also noted that the RBI tends to overtighten and "this is hurting growth rather than denting an inflation that is largely driven by supply shocks or global liquidity or depreciation due to inadequate FX reserves."
BofAML said the rupee's depreciation pushes up inflation by one percentage point and added that it expects the local currency to settle at the 60-65 against the dollar if the ongoing swap facility for deposits gets USD 20-25 billion.
The Indian rupee could test the 68 level again if banks are unable to mobilise deposits of up to USD 20-25 billion, it said.