Last week, Reserve Bank of India Governor Bimal Jalan announced a mini credit policy in Delhi, when he said the economy would grow 6 per cent in 2003-04 and the rate of inflation would be 5-5.5 per cent.

If he sticks to these projections in the Credit Policy on Tuesday, the RBI may find it difficult to maintain its soft rate bias despite the finance ministry's wish.

A close look at the yield curve of government paper in India and the US will reveal why Jalan may not find it easy to continue his soft rate drive. The yield curve in India is too flat.

The spread between the two-year paper and the 10-year paper in India is 62 basis points (one basis point is one hundredth of a per cent). In the US, it is 233 basis points.

In longer dated paper, the 10-30 year spread is 50 basis points in India, against 92 basis points in the US Market participants doubt the sustainability of the current yield curve and the spreads implicit in it.

The emerging consensus is that the yield curve will probably be steep in the 10-30 year paper segment. The growth rate target and the rising inflation rate may also lead to a steep yield curve in the 2-10 year paper segment.

A senior analyst with a multinational primary dealer said the huge rally in interest rate markets in the past two years was probably coming to an end. Yields on 10-year government bonds dropped by about 400 basis points during the period.

The factors responsible for this drop in yields include a slowdown in industrial output, benign inflationary expectations, large additions to foreign exchange reserves, the stability in overnight interest rates because of the interest rate corridor (operating through the liquidity adjustment facility) as well as the need to reduce the interest burden on government debt. An to the slowdown and the rising inflation rate may change the matrix.

The steep US yield curve is driven by expectations that the government will increase borrowing because deficit is likely to increase after the proposed tax breaks and a slowing economy. Long-term inflationary expectations are also reflected in the shape of the yield curve.

However, no such concerns are reflected in its current shape, leading the market to feel that the curve is unrealistic and may not be sustainable in the medium term.

While the US inflation rate has been close to 3 per cent year-on-year, in India it was at 6.17 per cent on April 5. The market is witnessing negative real yields up to the 10-year paper.

However, the issue of negative real rates is corrected if one takes into account the anticipated inflation of 5-5.5 per cent. But one cannot ignore the fact that the rate of inflation for manufacturing products has also moved up to 4.79 per cent. This essentially means that demand-pull factors cannot be ignored.

If Jalan plans to maintain a 5.5 per cent inflation rate and targets a 6 per cent growth, it will be difficult for him to justify reducing interest rates or maintain a soft interest rate bias against the backdrop of the current economic data. The liquidity-driven rally in interest rate markets may not last long.