The RBI announced its Third Quarter Monetary Policy Review today.

Key highlights were as follows: Repo and reverse repo rates hiked by 25 bps each to 6.50% and 5.50% respectively. CRR kept unchanged SLR leeway of 1% of net demand and time liabilities (NDTL) of banks extended till April 8, 2011 nd 2 LAF window extended till April 8, 2011.

RBIs Assessment Global Recovery in advanced economies seems to be consolidating and expectations of growth during 2011, particularly in the US, are being revised upwards. On the other hand, inflationary tendencies are clearly visible. In advanced economies, the earlier fears of deflation have given way to early signs of inflation. In EMEs, inflation has accentuated significantly recently. Importantly, while commodity prices are already high, they are expected to rise further on the back of improving US growth prospects. Domestic Growth Private consumption and investment demand are strong as reflected in the first half GDP data, while external demand is improving. While IIP data is volatile, other indicators like corporate sales, tax collections, and lead indicators of services sector growth suggest persistence of growth momentum. Real GDP growth forecast for 2010 11 has been retained at 8.5% with an upward bias. Domestic Inflation Since the November 2010 policy review, inflation pressures have re-emerged significantly. Primary food articles inflation has risen again sharply while non food and fuel inflation are already at elevated levels. Importantly, non-food manufacturing inflation has remained sticky. Risks remain, therefore, of food and fuel price increases spilling over into generalized inflation even as signs of rising demand pressure exist. These signs are reflected in indicators like rapid bank credit growth, robust corporate sales, rising input and output prices, and buoyancy in tax revenues. The baseline projection for WPI inflation for March 2011 has been revised upwards to 7% from 5.5%. Liquidity Liquidity deficit is on account of frictional and structural factors. The first of these is largely the above normal government cash balances which is expected to ease going forward as government balances adjust to the expenditure schedule. Structural factors include the widening difference between credit and deposit growth rates coupled with high currency growth. Banks will need to focus on structural causes of liquidity tightness. Interpretation The policy clearly highlights the RBIs discomfort with the change in trajectory of inflation since December even as the robustness of economic growth has been reaffirmed backed by strong private consumption and investment demand. Alongside, global commodity prices have risen further with better prospects of growth in the developed world, chiefly the US. To the extent that most of the recent renewed pressure on inflation has risen from primary articles and fuels group, the RBI has also in some sense defined the boundaries for efficacy of monetary policy in this environment. Thus it emphasizes that the role of monetary policy in the current inflationary situation is confined to containment and prevention of food and energy prices from spilling over into generalized inflation and anchoring inflation expectations. While retaining sufficient onus on itself, the RBI is also looking to the government to help out via supply side output enhancing measures as well as fiscal consolidation through improving the quality of expenditure.

The other noteworthy aspect is a heightened concern with respect to the external sector. Containment of the growing current account deficit is an explicit policy concern, especially since the RBI is worried over the quality of capital flows. Specifically, it is concerned that capital flows to India may suffer as other investment destinations become more attractive. Finally, the RBI expresses clear discomfort with the current level of credit growth. While monetary aggregates are growing in line with its projections, non food credit growth at 24% currently is higher than its indicative projection of 20%. Very importantly it states that while it will endeavor to provide liquidity to meet the productive credit requirements of a growing economy, it is important that credit growth moderates to conform broadly to the indicative projections. View Forward The policy review today was along expected lines and has invoked little reaction from the market. Given RBIs clear concern on inflation in context of strong private sector demand, rising commodity prices, and structural drivers of primary articles prices, we expect the rate hike cycle to continue going forward. We reiterate our call of 100 bps hike over calendar year 2011, the first of which has been delivered today. Given its near term concerns, the RBI may choose to front-load its rate hikes following up with another 25 bps in its March policy review. Given its broad comfort with M3 growth rate currently and its expectation that government spending should pick up, the RBI seems to be done with its open market purchases of government bonds for now. While in the near term, government bonds may remain range-bound owing to lack of supply and bank SLR buying on deposit growth, we expect yields to rise gradually overtime as market gears towards absorbing the new supply calendar starting April. Going by the expectation of stronger government spending from here on, system liquidity deficit should reduce over the next month before widening again as system pays advance taxes to the government in March. However, a sustainable improvement in the liquidity situation may be seen from April. With deposit accretion improving and, among other things, the RBI guiding lower credit growth, the current significant divergence between credit and deposit growth rates should subside as well going into April. These factors should ensure, in our view, that the current inversion in corporate bond curve starts to correct beginning the new financial year in April.

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