However, analysts dont expect the government to immediately free up diesel prices fully and the government may wait for crude prices to soften globally before doing so.
My sense is the government will time the complete deregulation of diesel prices when the under recovery is almost zero rupees, and that may not happen before October, said Sujan Hajra, chief economist at Anand Rathi Securities.
Prime Minister Manmohan Singh on Tuesday said the government would end control on diesel prices, signalling his resolve to push through reforms despite strong protests from political allies and opposition parties.
Last week, the government had allowed market prices for petrol, raised the price of other fuels including diesel, and said diesel may be freed in the future. The moves will bolster government finances and open up a key sector long dominated by state-run firms.
Inflation pressures are expected to surge following the increase in fuel prices and analysts are revising up their wholesale price index (WPI) projections for 2010/11.
The finance ministry had on Friday said the price rises would increase headline inflation by 0.9 percentage points. Indias most closely watched WPI inflation unexpectedly accelerated in May to 10.16% year-on-year while the food price index also rose sharply in mid-June to 16.9%.
Every two rupee-increase in diesel prices will have a 30 basis points rise as direct impact on WPI, and another 30 basis points by an indirect effect, Hajra said.
However, by October, Indias headline inflation is widely expected to ease, and a diesel price increase may therefore have a muted upward impact on inflation.
There may not be a major impact on inflation due to diesel price deregulation as I dont expect oil prices to rise globally in the next three to six months, said A Prasanna, economist, ICICI Securities Primary Dealership.
Reforms in diesel prices would also make the retail market more lucrative for private firms such as Reliance Industries), Essar Oil and Royal Dutch Shell as diesel accounts for a third of Indias oil demand.