The Reserve Bank of India's traditional policy dilemma of reconciling economic growth with price stability has once again come into sharp focus. Last week the central bank hiked the short-term policy rates, the repo and the reverse repo rates, by 0.25 percentage point each. Taking into account the unexpectedly large 0.75 percentage point increase in the Cash Reserve Ratio announced in the January policy, the latest move confirms the shift to a tighter monetary stance. The CRR hike resulted in an impounding of nearly Rs.36,000 crore of bank deposits. Evidently, the developments since January, especially the unrelenting rise in the inflation rate, suggested stronger, more overt signals from the RBI in the form of a hike in the repo and the reverse repo rates. Many financial market participants, of course, were taken by surprise. Banks close their books for the financial year on March 31 and interest rate changes have enormous implications for their balance sheets. Besides, since the annual policy statement for 2010-11 is due on April 20, many assumed that the RBI would not act until then. However, there have been several occasions in the recent past when monetary measures were announced outside the policy dates. More specifically, the third quarter review in January left no one in doubt that the RBI would intervene proactively and strongly if and when necessary.

Economic growth has been underpinned by a strong performance of the manufacturing sector. The acceleration in the growth of the capital goods sector points to a revival of investment activity. After declining for 13 successive months, exports have been rising since November 2009, but more significantly it is domestic demand that has been driving the recent economic growth. With supply of goods struggling to catch up, inflation concerns are growing. Despite some slight moderation, food inflation remains at unacceptably high levels. The overall inflation in February based on the wholesale price was just short of double digits, while consumer price inflation, as measured by various indices, has accentuated further. The hike in the policy rates has to be seen as a continuation of the process of moving away from the cheap monetary policy that began in October 2009 and was carried forward in January. Given the still-abundant liquidity, several banks have said that they will not be marking up their lending rates immediately. It is however highly unlikely that they can put it off for long.

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