The Reserve Bank of India [Get Quote] on Thursday hiked the ratio of mandatory deposits that banks need to maintain with it by 50 basis points to suck out about Rs 18,500 crore (Rs 185 billion) from the system, complementing efforts of the government to fight price rise.

The decision of the central bank to raise the Cash Reserve Ratio (CRR) from 7.5 per cent to 8 per cent in two phases comes within 24 hours of Finance Minister P Chidambaram assuring the Lok Sabha that RBI would assess the monetary situation and take appropriate action to curb inflation.

Considering the gravity of the price situation, which has pushed inflation to a three-year high of 7.14 per cent, the RBI has tinkered with the monetary policy even ahead of the April 29 announcement of its annual credit policy for 2008-09.

"In the light of the current macro-economic, monetary and anticipated liquidity conditions, and with a view to containing inflation expectations, it is essential to take appropriate action on an urgent basis," RBI said in a statement.

"On a review of current liquidity situation, it is considered desirable to increase the CRR of the scheduled commercial banks... by 50 basis points to eight per cent in two stages," it added.

The hike in CRR may lead to tightening of money supply, forcing banks to raise lending and deposit rates. IBA chief executive H N Sinor said the hike was expected to rein in inflation, but he did not see banks immediately increasing interest rates as they would wait to see the outcome of the credit policy.

The RBI's move, according to Oriental Bank of Commerce [Get Quote] executive director Allen C A Pereira, could lead to increase in lending rates for sectors like personal loan, home loan for the purchase of second house.

It would be effort of the bank to ensure that credit goes to deserving and the productive sector and cut down the exposure in the unproductive areas, Pereira told PTI.

Some of the banks could increase Prime Lending Rate depending on the cost of resources to maintain net interest margin, he said.

The CRR rate hike will come into effect from April 26 and May 10, with 0.25 per cent increase in each phase.
The central bank last hiked CRR by 0.5 per cent to 7.5 per cent in October 2007 to curb liquidity in the system, even though inflation was hovering around a five-year low of over 3 per cent. The move then was aimed at taming inflationary expectations.

However, now inflation has risen to over seven per cent. Even though it has cooled to 7.14 per cent in the first week of this fiscal after rising to a 40-month high of 7.41 per cent in the previous week, it is still at a three-year high.

The current move is aimed at controlling high level of inflation, even though many experts believe that soaring prices could be cooled by augmenting supply and not through monetary measures.

"The year-on-year Wholesale Price Index-based inflation, which was 3.83 per cent on January 12, 2008 (at the time of announcement of third quarterly review of credit policy), increased to 7.41 per cent on March 29 and remained at 7.14 per cent as on April 5 and its overall impact on inflation expectations requires to be monitored and moderated," RBI said, announcing the hike in CRR. RBI also sucks out or injects liquidity in the system through its daily repo operations.

The fact that liquidity in the system was rising of late was evident from the fact that the RBI absorbed Rs 40,088 crore (Rs 400.88 billion) daily between April 3 and today as against average daily injection of Rs 27,385 crore (Rs 273.85 billion) during March 17-31.

Even though RBI had maintained status quo in its policy rates and CRR in its third quarter review in January this year, the central bank had clearly stated that liquidity management will continue to assume priority.

• Inflation, the silent killer!