The challenge that the Reserve Bank of India (RBI) faced at the time of formulating its second quarter review of monetary policy was to support the fragile recovery without allowing inflation to get out of hand. Supporting growth required that the accommodative policy of recent times be continued, while rising inflation called for an early exit.

Arguments favouring a rate hike

Inflationary concerns. WPI inflation has turned positive while CPI inflation remains in double digits. RBI has revised its estimate of WPI inflation for end-March 2010 from 5 per cent in the first quarter review to 6.5 per cent in the second quarter review.

Those arguing against a rate hike would say that the current bout of inflation is driven by food prices, and monetary policy is not particularly effective in containing inflation driven by supply shortages. However, there is always the chance that food inflation could breed broader inflationary expectations and have a second-round impact on other, core items.

Since monetary policy acts with a lag, a case could be made out for acting ahead of the curve and raising rates in this policy review.

High level of liquidity. The other argument favouring a rate hike arose from the high level of liquidity within the system. Since March 2009, banks have been depositing over Rs 100,000 crore daily in RBI’s reverse repo window — a strong pointer to high liquidity that could result in undesirable asset price inflation. With the influx of foreign capital having resumed, the level of liquidity is only likely to rise. The large liquidity overhang could make the task of fighting inflation harder.

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