Though the repo rate hike was limited to 25 basis points, the RBI's policy statement is very hawkish on inflation and states in no uncertain terms that further rate hikes may be required in future.

The Reserve Bank of India has hiked the repo rate by 25 basis points to 7.5 per cent, but left the reverse repo rate unchanged at 6 per cent in the latest quarterly review of its monetary policy review. Repo rate is the interest rate at which the RBI lends money and reverse repo rate is the rate at which the central bank borrows money from the market. The bank rate and cash reserve ratio (CRR) have been left unchanged at 6 per cent and 5.5 per cent respectively.

While the 25-basis point hike in repo rate was almost certain, stock and money markets were expecting at least a 25 basis increase in the reverse repo rate as well. As liquidity conditions have been tight in recent months, the RBI has been infusing funds through its liquidity adjustment facility (LAF). This scenario makes the repo rate the key operating rate and by hiking it the RBI is sending a clear message.

Stock market recovered sharply and bond market rallied after the policy announcement. However, traders and investors have shed most of their earlier excitement after a reading of the detailed policy statement by RBI

The central bank's policy statement is even more cautious than earlier on inflationary risks which persist despite the monetary and fiscal measures. Though the central bank has maintained its inflation target range at 5 per cent to 5.5 per cent, there are many over-cautious references and statements in the policy statement. The latest statement also repeats the risks of overheating in the economy, though the RBI admits such risks could be transitional in nature.

The RBI policy statement takes note of both demand and supply side pressures on inflation. "Demand pressures appear to have intensified, reflected in rising inflation, high money and credit growth, elevated asset prices, strains on capacity utilisation, some indications of wage pressures and widening of the trade deficit. There are increased supply side pressures in evidence from prices of primary articles", the statement said.

Money supply growth during the current year at 20.4 per cent is way above RBI's target of 15 per cent. The central bank believes the growth in capital inflows would continue, which would make its job tougher. "The enduring strength of capital inflows poses a challenge to monetary and liquidity management. In the event of demand pressures building up, increases in interest rates may be advocated to sustain growth in a non-inflationary manner but such action, apart from associated costs for growth and potential risks to financial stability, increases the possibility of further capital inflows so long as a significant part of these flows is interest sensitive and explicit policies to moderate flows are not undertaken. These flows can potentially reduce the efficacy of monetary policy tightening by enhancing liquidity", the statement said.

Non-food credit by commercial banks continues to expand at a fast rate and the growth so for during the current financial year is 31.2 per cent. "It is important to note that bank credit continues to grow at a rapid pace for the third year in succession and the rates of growth are clearly excessive, warranting measures to moderate growth even after accounting for the relatively low level of credit penetration in our country and the structural transformation of the economy that is underway", the RBI said. The central bank is clearly worried about the 83.9 per cent growth in credit to commercial real estate and 34.3 per cent rise in retail lending so far this year.

Deposit growth for commercial banks so far this year is at 12.9 per cent, much lower than the credit growth. "Banks have been drawing down their investments in gilts sizeably to accommodate credit demand, including to levels close to the minimum SLR in some cases. Mismatches between the sources and uses of funds persist. The system level incremental non-food credit-deposit ratio remains high at 91 per cent, but at even higher levels for some banks", the central bank said.

The RBI has further tightened the provisioning requirements for banks' exposure to real estate, capital markets and consumer loans to cool down the credit growth. "It is essential to recognise the links between accelerating inflation and escalating asset prices, even when no view is taken on the appropriateness of such levels of asset prices. Large movements in asset prices impact consumer demand through wealth effects and often, accelerating inflation tends to encourage investments in assets as a hedge. Thus, concerted actions in fiscal, external, monetary and prudential policies would be appropriate to meet such mutually reinforcing situations", RBI said.

To stem the rise in FCNR and other non-resident deposits and advances against these deposits, the interest rate ceilings on such deposits have been reduced. Loans above Rs20 lakh against such non-resident deposits have been prohibited to avoid upward pressure on asset prices from this source of funding.

The RBI believes that the economic momentum and sustained growth in credit and money supply prove that monetary policy is still accommodative. "To the extent the current inflationary pressures are attributable to monetary conditions, it is essential to undertake appropriate measures, in continuation of those already taken and in the light of anticipated developments. Evolving conditions underscore the importance of persevering with further withdrawal of policy accommodation in a timely manner to ensure both price and financial stability", the RBI said.

In simple language, the RBI is saying that there is still scope for interest rate hikes in future and there would be no hesitation to do so.

This is bad reading for analysts and borrowers who were expecting interest rates to stabilise during the next financial year. Retail borrowers would be the worst hit as the central bank would continue its attempts to slow down retail lending growth.