As per the RBI, demand pressures have remained strong, while actual inflation so far has been even higher than expected. In particular, non-food manufactured product inflation has been significantly higher than the average rate of 4% over the last six years. Crude oil prices remain volatile and are a major risk factor. RBI expects the inflation to remains under pressure with the recent increase in domestic administered fuel prices and the minimum support price for certain food items.

RBI accepts that there are signs that growth is beginning to moderate, particularly in respect of some interest rate sensitive sectors. However, there is no evidence, as yet, of a sharp or broad-based slowdown. Several indicators such as exports and imports, indirect tax collections, corporate sales and earnings and demand for bank credit suggest that demand is moderating, but only gradually.

The RBI has retained the baseline projection of real GDP growth at 8.0%, as set out in the 03 May 2011 Policy Statement. Meanwhile, the baseline projection for WPI inflation for March 2012 is revised upward from 6.0% with an upside bias, as indicated in the 03 May 2011 Policy Statement, to 7.0%. RBI indicated that inflation is expected to remain at an elevated level for a few more months, before moderating towards the later part of the year.

The current trends in money supply (M3) and credit growth remain above the indicative trajectory of the Reserve Bank. Keeping in view the evolving growth-inflation dynamics, the indicative projection of M3 growth for 2011-12 is revised downwards from 16.0%, as set out in the May 3 Policy Statement, to 15.5%. Non-food bank credit growth projection is also revised downwards from 19.0% to 18.0%.

Global Economy

The pace of global expansion moderated in Q2 of 2011. Several factors contributed to this - high oil and other commodity prices, supply chain disruptions from Japan, sovereign debt concerns in the euro area, and continued weakness in the US housing and labour markets. Concerns over the euro area sovereign debt problem re-emerged on the back of Greece's deteriorating fiscal position, downgrading of Portugal's sovereign debt rating, and most significantly, signs of stress in Italy's sovereign debt. The agreement reached by the euro zone leaders in their meeting on 21 July 2011 is a positive development, while its effective implementation remains to be seen.

The unemployment rate edged up in the US and showed no improvement in other major advanced economies. The US national home price index declined further in Q1 of 2011. Despite sluggish economic activity, inflationary pressures also emerged in advanced economies under the impact of high commodity prices. Core inflation has picked up in the US and the euro area.

RBI expect the GDP growth at 8.5% during 2010-11 could undergo some upward revision since the new IIP series (base: 2004-05) shows that industrial growth did not moderate in the second half of 2010-11. Latest available data for 2011-12, however, suggest some moderation in economic activity. The increase in the IIP by 5.7% in April-May 2011 was lower as compared with the increase of 10.8% in the corresponding period of last year. Merchandise trade, however, registered strong growth with exports expanding by 46% during Q1 of 2011-12. As regards the monsoon, its performance till the third week of July 2011 was close to normal, which bodes well for overall production. However, its spatial distribution indicates possible pressure on yields of coarse grains, pulses, oilseeds and cotton. The baseline projection of real GDP growth is retained at 8.0%, as set out in the May 2011 Policy Statement.

Inflation continues to be the dominant macroeconomic concern. Both the level and the persistence of WPI inflation are a cause for concern. The persistence of high non-food manufactured products inflation suggests that producers, operating at high levels of capacity utilisation, are able to pass on rising commodity input prices and wage costs to consumers. Early corporate results for Q1 of 2011-12 suggest some moderation in margins. However, such moderation so far has been modest, implying that pricing power persists.

The headline WPI inflation rate for the first quarter of this fiscal year remained stubbornly close to double digits and inflationary pressures continued to be broad-based. Both the level and the persistence of WPI inflation are a cause for concern. Inflationary pressures are clearly very strong, notwithstanding signs of moderation of economic activity. RBI has revised the baseline projection for WPI inflation for March 2012 upward to 7.0% from 6.0% set out in the May 2011 policy.

The upside risks to the inflation outlook materialised since May 2011 include:

• The upward revision in prices of petroleum products;
• The significant increase in the minimum support prices (MSPs) for some agricultural commodities; and
• The persistence of non-food manufactured products inflation at elevated levels reflecting underlying demand pressures.

Factors shaping up inflation outlook going forward:

• The overall performance of the south-west monsoon; both its spatial and temporal distribution.
• Crude oil prices whose outlook for the near future is uncertain and could remain volatile
• Policy decisions with regard to increase in prices of petroleum products and other administered items.

Risks to RBI's indicative projections of growth and inflation for 2011-12

• Uncertainty about the future path of global commodity prices, especially oil;
• Uncertainty about capital flows from the perspective of financing the current account deficit;
• Risks to food inflation stemming from the monsoon performance, higher minimum support prices and inadequate supply response pertaining to protein-rich items; and,
• Significant upside risks to the projected fiscal deficit for 2011-12 as fiscal deficit has been a key source of demand pressures.

In response to the monetary policy measures initiated by the Reserve Bank, scheduled commercial banks (SCBs) have been raising their domestic deposit rates. During 2010-11, the modal term deposit rate of all SCBs rose by 165 basis points (bps). It rose further by about 60 bps during April-July 2011, ie 225 bps from March 2010.

The deposits growth has improved from 17.4% in early April 2011 to 18.4% in early July 2011, while non-food credit growth decelerated from 21.3% in March 2011 to 19.5% as on 01 July 2011. Non-food credit growth was broad-based with credit to industry, services and personal categories registering higher growth. Disaggregated data suggest that credit to the industrial sector continued to be led by infrastructure.

Since July 2010, the modal Base Rate of banks has increased by 225 basis points. The Base Rate system of loan pricing coupled with deficit liquidity conditions has increased both the strength and the transparency of the monetary transmission process.

Liquidity conditions

Consistent with the policy stance, liquidity conditions have generally remained in deficit mode so far in 2011-12. The average daily net injection of liquidity through the liquidity adjustment facility (LAF) window during this period till July 22 was around Rs 48000 crore, which was within 1% of NDTL.

The current trends in money supply (M3) and credit growth remain above the indicative trajectory of the Reserve Bank. Keeping in view the evolving growth-inflation dynamics, the indicative projection of M3 growth for 2011-12 has been revised downwards from 16.0%, as set out in the May 2011 Policy Statement, to 15.5%. Non-food bank credit growth projection has also been revised downwards from 19.0% to 18.0%.

Monetary Policy Stance

• To maintain an interest rate environment that moderates inflation and anchors inflation expectations;
• To manage the risk of growth falling significantly below trend;
• And, finally, to manage liquidity to ensure that monetary transmission remains effective, without exerting undue stress on the financial system.

Expected Outcomes

• First, the cumulative impact of past actions on demand will be reinforced;
• Second, the credibility of the commitment of monetary policy to controlling inflation, and thereby to keeping medium-term expectations anchored, will be maintained;
• Third, the policy actions will reinforce the point that in the absence of complementary policy responses on demand and supply sides, stronger monetary policy actions are required.

The next mid-quarter review of Monetary Policy for 2011-12 will be announced through a press release on Friday, 16 September 2011.

The Second Quarter Review of Monetary Policy for 2011-12, including developmental and regulatory policies, is scheduled on Tuesday, 25 October 2011.

As regards guidance for the future, going forward, the monetary policy stance will depend on the evolving inflation trajectory, which in turn, will be determined by trends in domestic growth and global commodity prices. A change in stance will be motivated by signs of a sustainable downturn in inflation.

Tushar Poddar, Chief Economist, Goldman Sachs India

We see a very high bar for the RBI to hike further on 16 September, unless there is a significant upside surprise to inflation. Although the rhetoric in the policy statement was hawkish, given the extent of the rate hike, we think the RBI was unlikely to dilute the impact of its move by signaling a pause at this stage. If rate hikes are done, then this would lead to a gradual bottoming out of the investment cycle, which we expect to happen by end-FY12 and a recovery thereafter. We believe the move is bullish for the INR due to higher carry; and for paid positions at the long end of the swap curve. The RBI made its future rate action dependent on the trajectory of inflation. It said ‘change in policy stance to be driven by signs of a sustainable downturn in inflation'. The RBI noted that it had to take stronger action in the absence of supply-side responses and deterioration in the fiscal balance. The RBI listed the factors that would determine the inflation outlook—the performance of the monsoons, the outlook for crude prices, and policy decisions regarding administered fuel prices. Our view remains that of a normal monsoon, not much upside to crude, and no further increases in locally-administered prices. Therefore, the policy statement does not fundamentally change our inflation outlook.

Indranil Pan, Chief Economist, Kotak Mahindra Bank

With the repo rate now at 8%, the RBI has raised policy rates by 125 bps in 3 months. The tone of the policy statement was decisively hawkish, as the RBI side-stepped signs of growth moderation and instead focused on inflation. The RBI will move away from its current anti-inflationary policy stance only when inflation shows a "sustainable downturn". Thus, the RBI has kept the door ajar for more monetary tightening. We expect the RBI to hike the repo rate by 25 bps in the September mid-quarter policy review and the chances of a further 25 bps hike in October looks fairly high, though could be significantly data driven. Global commodity prices could be crucial as relatively higher risk-appetite with near-term resolutions to debt worries in Europe as also in US (likely) could push up commodity prices. Financial markets were evidently shocked by today's actions and the yields on the 10-year benchmark G-Sec jumped up by 11 bps to 8.42% from 8.31% at opening.

Jay Shankar, Chief Economist, Religare Capital Markets

Our estimate for average inflation in FY12 remains at 8%, now with some upside risk. The peak is still likely to be close to 10.5% around Sept., but the downhill curve thereafter is likely to have lower gradient until December. The risks to our estimates of inflation trajectory have played themselves out somewhat in the last three months – namely domestic fiscal policy remaining largely accommodative, monetary policy in most developed economies remaining expansionary helping global liquidity and crude remaining sticky above $115/bbl. Our FY12 GDP growth estimate remains at 8.2%. We expect another 25bps hike on 16 September, without ruling out further rate hikes completely. Domestic fiscal consolidation, global commodity prices, resolution to Eurozone problems and the progress of the monsoon remain the key now.

Rohini Malkani, Economist, Citi India

In a bid to tackle the persistence of 9%+ inflation, the RBI surprised the market by raising rates by 50bps taking the repo to 8%. Bond yields edged up over 10bps with the 10 year currently trading at 8.33%. With inflation likely to remain elevated at 9%+ and even touch double-digit levels on revisions in the coming months, we expect the RBI to elongate its tightening cycle by a further ~50bps by Dec. While maintaining its 8% GDP estimate, the RBI has raised its March 12 inflation estimate to 7% from 6%. This remains lower than our estimate of 8%. With banks immediately passing on the rate hike, we see further downside risks to our 8.1% GDP estimate.

Sujan Hajra, Chief Economist, Anand Rathi Financial Services

Despite aggressive monetary tightening, the average inflation rate has been above 9.5% in the last 15 months. Moreover, the impact of the fuel price hike will be seen in the coming months. We do not see any triggers that can substantially soften inflation till Sep '11. Thereafter, we expect inflation to start softening. We expect real growth to play a bigger role in future in deciding the direction and pace of monetary policy.

RBI's action to raise policy rate by 50bps against market expectation of 25bps in part reflects its desire to send a strong anti-inflationary message to market participants and in part reflects front loading of rate hikes. We expect another 25bps rate hike and a pause thereafter to gauge the evolving growth-inflationary dynamic; however policy easing is not on the cards yet. While, inflation will ease in 2HFY12, in part due to base effect, full year inflation will average over 8%. While there have been signs of growth decelerating, we do not expect an abrupt deceleration in growth. We maintain our full year FY12 GDP growth estimate of 7.6%, down from 8.5% in FY11.

Anjali Verma, Economist, MF Global Securities

In our understanding, RBI can tolerate the economic growth moderating to 7.75% as a result of higher interest rates in order to bring inflation under control. As of now, we maintain our GDP estimate at 7.7%, we would wait for the Q1GDP numbers and completion of monsoon, to make any downward revision to our estimates. As we understand, so far the maximum impact of higher interest rates has come in the form of slowing investment, which can have medium-term impact on the economic growth cycle. We have maintained that year-end inflation would be above 7%. We have had an estimate of 50-75bps repo rate hike till December'11; after today's policy announcement, we maintain the forecast of balancing 25bps repo rate hike. Risk to our estimates: Below-normal monsoon, sharp changes in commodity prices, domestic/global economic growth, and global liquidity. Banks are expected to increase the lending and deposit rate by 50bps, to result in further slippages in investments and consumption.

Sandesh Kirkire, CEO, Kotak MF

The unexpected hike in the repo rate by 50 bps is indicative that RBI has taken a hawkish stance vis-a vis the inflation outlook. This is ostensibly on account of the marginal cut in the monsoon forecast, continued buoyancy in the oil prices and increased debt solvency challenges in the ‘West'. The resultant moderation in the domestic economic growth rate may be more than expected, and the deceleration in the credit growth may help augment the gilt appetite of the PSU banks.

Sanjeev Zarbade, Vice President(Private Client Group Research), Kotak Securities

The RBI has unexpectedly increased policy rates by 50bps. It has clearly stated that, the focus is only on inflation and it is fine with growth moderating slightly. However, it has also stated that, it will act if growth rates fall significantly. Given the negative surprise, markets reacted with a sell-off (The Nifty is down 90 pts). Interest rate sensitive sectors like Banks, Autos and Real Estate have witnessed higher selling pressure. In addition to this, the rate hike is also particularly taxing for debt-laden companies as they would have to suffer higher interest charges (Rcom is down 6%).
Sector-wise, Banks will see growth rates moderating. RBI has reduced credit growth target to 18% from 19%. Most banks will increase rates and that will contract demand. The NIMs might come under some pressure, atleast initially. Interest rate sensitives will sentimentally be under pressure. Across sectors, the interest rate hikes will pinch profit growth. We see growth outlook being revised downwards for sectors like Banks, Autos, Real Estate and Infrastructure.

Ramanathan K, CIO - ING Investment Management

The 50 bps rate hike was above expectations. The more important point is the fact that there is no clear indication that the RBI is at the stage of pressing the pause button. I still feel that we are at the end of rate hike cycle and any further rate hike beyond 25-50 bps is going to impact growth significantly below the trend level. While RBI rates are around the 8% levels the bank 'base rates' are in the range of 9.5-10.5%. The average lending rates (for working capital and term loans) to lower than AAA corporates are between 10.5-14%. At these high interest rate levels investment demand is surely expected to get impacted as incremental capex plans of corporates would be put on hold.

RBI spewed negative surprise with steep 50 basis points hike in repo rates, as against market expectations from a pause to another baby step of 25 basis point hike in repo rates. Aneesh Srivastava, CIO - IDBI Federal Insurance Company rightly said, "With the announcement of 50 bps hike, RBI has taken the Repo Rates to 8%. Such high rates of 8%-plus were prevailing in June 2008 to fight inflation which was at 10%. High rates at that time had retarded the GDP growth drastically to less than 6% and IIP too had started contracting. A gloomy global macroeconomic scenario was also one of the reasons for such a bleak growth environment at that time and similar uncertainties are present even today in US & Europe".