The 1-year overnight index swap (OIS) rate, which is most sensitive to near-term rates cuts, fell to a seven-month low after the December wholesale price index (WPI) rose 7.18 percent from a year ago, according to data on Monday.
That was below expectations of a 7.4 percent rise, and marked a three-year low.
Some analysts say the Reserve Bank of India could even deliver a rate cut of 50 basis points at its policy review on Jan. 29, especially after core inflation eased to 4.2 percent last month from around 4.5 percent in November.
"The moderation in the core inflation is quite encouraging and makes a case for higher rate cut in the forthcoming policy meet," said Shakti Satapathy, a fixed income analyst with AK Capital, referring to a 50 bps cut.
"Having said that, the comfortable yield levels and lesser threat of a high interest scenario in the coming days might push the central bank into taking a conservative rate cut of 25 bps in a staggered manner over next two policy meets."
The benchmark 10-year bond yield was down 7 basis point at 7.80 percent, its lowest since Aug. 9, 2010, as of 0730 GMT.
Yields have eased as much as 35 basis points in a rally that started on Dec. 21 on the back of hopes for interest rate cuts, as well as increasing confidence in the government's resolve to contain its fiscal deficit.
India has scheduled only one weekly bond issuance this month and recently announced a hike in railway passenger fares, while the federal cabinet is soon expected to consider a hike in diesel prices.
The 1-year rate fell 4 bps to 7.49 percent, its lowest since June 14. The benchmark 5-year OIS rate was down 1 bps at 7.17 percent.
The negative spread between the two rates has narrowed to 32 bps from 48 bps at the end of 2012, largely driven by the fall in the short-end on rate cut expectations.