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Deflated by high inflation

The Reserve Bank of India in its continuing fight against inflation has raised the very real prospect of runaway prices eating into India's growth prospects.

india Updated: Mar 17, 2011 20:31 IST

The Reserve Bank of India in its continuing fight against inflation has raised the very real prospect of runaway prices eating into India's growth prospects.

Thursday's quarter of a percentage point rise in signal rates point to further hikes as the central bank revised upwards its projection for inflation by March 2011 to 8%. More worrying is its prognosis of the current phase of rising prices.

While prices on the farm have cooled off as expected, core inflation - minus the more volatile food and energy prices - shot up from 4.8% in January to 6.1% in February, significantly higher than the trend.

Demand-led pressure is allowing manufacturers to pass on higher input prices to consumers, a scenario the RBI hopes to address through further increases in the interest rate.

Rate hikes are not costless, however. Investment demand in the country has not fully recovered from the 2008 credit crises and costly money weighs on decisions to increase capacity across the economy.

Bank deposit rates have kept in step with the signals from Mint Road but lending rates are yet to align with them and are far from having peaked.

Contractionary monetary policy thus adds to the significant risks the economy faces in maintaining its growth momentum.

Principally, rising international oil prices that have not yet been absorbed by Indian consumers.

The government's attempt to shield them from the surge could play havoc with its fiscal deficit target for the next year.

The central bank thus cautions the government to spend wisely given that its fuel and fertiliser subsidies are almost certain to balloon.

"The budget for 2011-12 indicates some easing of demand pressures from the fiscal side, thus creating space for private investment, but this will materialise only if commitments to contain subsidies are adhered to," the credit policy says.

The RBI draws some satisfaction that its monetary tightening is showing results. While credit growth remains above target, a squeeze has been felt since December as banks continue to raise their lending rates.

The latest increases in the rates at which banks borrow from and lend to the RBI are expected to make liquidity in the banking system come closer to the deposits held by them. There is also some cheer on the trade front.

The central bank reckons the current account deficit will clock in nearly a full percentage point lower than earlier expected, at around 2.5% of the GDP.

But there is a strong case for policymakers to focus on the quality of capital inflows so that the balance of payments is sustainable.

The news from across the globe is not to the central bank's liking, with the West Asia crisis and the Japanese nuclear disaster both contributing to the pressure on energy prices.