Presenting its first ever mid-quarter review of the credit policy, the Reserve Bank of India surprised the markets on Thursday with a larger than expected hike in the short-term policy rates. The reverse repo and the repo rates have been marked up by 0.50 percentage point and 0.25 percentage point respectively. This, while narrowing the gap between the two short-term rates, underscores the central bank's unrelenting focus on inflation. Inflation at 8.5 per cent according to the new, updated series and 9.5 per cent according to the old series is well above the RBI's target range of 6 per cent by the end of the year. The higher reverse repo rate will help the RBI mop up surplus funds in the banking system. However, there is no surfeit of liquidity at the present moment, going by such indicators as sluggish credit off-take, widening current account deficit, and subdued money multiplier. Hence it is very likely that commercial banks, which are beginning to pay more for their deposits, will heed the other short-term rate signal and increase their lending rates. The process will be gradual since the new base rate mechanism gives them some leeway in fixing their lending rates.

Without in any way lowering its guard against inflation, the RBI has said that the monetary policy will henceforth be based on the totality of the macroeconomic circumstances. The obvious inference is that the period of aggressive monetary tightening is finally coming to an end. From now on, policy action will be guided equally, if not more, by the dynamic macroeconomic situation at home and the still uncertain outlook abroad. Recent economic data in India are positive: a GDP growth of 8.8 per cent for the first quarter and a 13.8 per cent industrial growth during July. Monsoon rainfall has been good and agriculture is expected to stage a recovery. However, there are genuine concerns that the external economy is dependent on volatile capital flows. The developed countries, though well out of recession, are witnessing a feeble recovery. Europe has been resilient in the face of the severe debt crisis but the situation in the United States is still gloomy. Finally, the need to keep a handle on the fast-changing economic environment explains the Bank's decision to increase the number of policy reviews in a year from four to eight. Leading central banks the world over communicate with the markets frequently, anything between eight and 12 times. Even as the RBI retains its right to step in whenever necessary, any increase in frequency reduces the scope for monetary intervention between two policy statements.

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