The Reserve Bank of India?s decision to raise its reverse repo rate (the rate at which the RBI absorbs funds) by 25 basis points to 5.5 per cent has taken the financial markets by surprise. The Central bank had mentioned that inflation was well under control in its review of macroeconomic and monetary developments on Monday. This led market participants to believe that the RBI would not tinker with interest rates in its third quarter review of monetary policy. Moreover, liquidity has been tight in the money market in recent weeks and this had led to the belief that the RBI would not exacerbate the situation by raising rates. Since interest rates had gone up in the market as a result of the tightening, the assumption was that the market had already done what the RBI wanted to do, and there was, therefore, no need to raise rates. Unfortunately for the market, the RBI has proved all these assumptions wrong.

What are the reasons for the tightening? In its mid-term review last October, the RBI had raised the reverse repo rate to 5.25 per cent in an effort to contain inflationary expectations. This time, it says that ?inflation expectations have stabilized? and there is a need for pre-emptive action. There are several reasons for this. First, the RBI believes that the ?base outline for growth has further brightened in recent months?. Together with this upward bias to growth prospects, the RBI has also drawn attention to the risk to credit quality, and it has asked banks to undertake a segment-wise analysis of credit activity with special emphasis on sectors where the rise in credit has been rapid. It has talked about the growth in asset prices, including the rise in house prices. It has pointed to the rising current-account deficit. In simpler terms, the bank believes that there is an ?incipient build-up of potential demand pressures?. At the same time, the RBI has pointed out that growth in non-food credit is likely to be well above the growth forecast earlier, while money supply growth will also be significantly higher than earlier projections. Add to these prospects for higher growth and enhanced liquidity a possible rise in crude oil prices, and the Central bank believes that ?the risks to inflation from both domestic and global developments remain high?. In the circumstances, the RBI has opted to nip inflationary risks in the bud. Banks have already raised deposit rates and are under pressure to raise lending rates. The RBI rate hike is likely to act as the signal.