Convinced that any amount of monetary measures will not be able to rein the galloping inflation, which has recorded a frightening two-year high of 6.73 per cent (going by the latest figures), the government today cut fuel prices. It reduced petrol rates by Rs2, while diesel will now cost Rs1 less.

The move is expected to set-off a chain reaction in the supply chain by cooling off prices of commodities. The government has been mulling over the unrelenting spike in inflation for the last few months.

Unlike monetary measures, the latest move by the government is likely to have an immediate effect on price rise. To begin with, prices of agricultural commodities are likely to show a cooling effect as the transportation cost - a key component of overall price assessment factors, will come down.

It was in response to a sustained demand from the markets and analysts that the Government had to act on the supply side front to rein the rising inflation, instead of waiting for the RBI to take action. While it had taken a few measures in this direction last month, they did not seem to have been enough of a curbing mechanism.

The petroleum minister said the price cut burden will be met by a combination of new oil bonds and internal resource mobilisation by the oil companies. The government has also said that it would cut down the duty on petro products to cushion the rising losses by the oil companies.

Thanks to the assembly elections in some states, including the politically important Uttar Pradesh, the latest step by the government to tame inflation indicates that the centre has realised that it is time to act.

The cumulative losses by the oil companies due to the price cut are estimated to be under Rs50,000 crore. However it is expected that there wont be much of an impact on the bottom lines of oil companies as most losses will be compensated by import duty cuts, pushing of fresh oil bonds.

According to Senior IOC official, the under-recoveries on diesel will go up from Rs1.35 to Rs2.35, while over-recoveries on petrol will be neutralised.

The reduction, the second in less than three months, was announced after a meeting of prime minister Manmohan Singh, finance minister P Chidambaram and petroleum minister Murli Deora.

The two key motor fuel prices were last reduced by an identical amount in November. Announcing the price cut, Deora said the decision followed concerns expressed by UPA chairperson Sonia Gandhi about rising inflation.

The finance ministry is also likely to make duty adjustments, possibly reduction in excise rates. An announcement in this regard is expected soon.

Also, the government was in favour of ensuring that since global crude oil prices had stabilised, the common person should not be burdened any further, especially since inflation had also risen to new peaks.

In June 2006, the Indian oil basket was at $67 per barrel, which jumped to $75 by August. But since then there has been a consistent dip in the basket prices, which went down to $52 per barrel in recent weeks.

Moreover, gradual duty adjustment is in line with the government's policy.