Mumbai: Reserve Bank of India left interest rates on hold on Thursday but warned inflation was still well above its comfort level and unveiled steps to address persistently tight liquidity, adding to the possibility that it will resume monetary tightening in January.

The Reserve Bank of India has been the most aggressive major central bank in Asia, lifting interest rates six times since March to fight surging prices being spurred by rising food costs in an economy growing at nearly 9%.

Thursday’s liquidity moves, combined with the prospect of renewed inflationary pressures, increased the likelihood that the central bank’s next rate increase could come next month.

“The very hawkish tone of today’s statement has persuaded us that the next repo and reverse repo rate hike is most likely to come at the RBI’s next meeting on 25 January," said Robert Prior-Wandesforde, an economist at Credit Suisse in Singapore.

Prior-Wandesforde had previously expected the central bank to refrain from raising rates until March, and now expects 75 basis points of tightening by August.

Still, bond yields and swap rates tumbled after the RBI announced steps to cut the statutory liquidity ratio (SLR)—the minimum level of deposits banks must hold in government approved securities—to 24% from 25%, and unveiled $10.6 billion worth of bond purchases over the next month.

This year’s tightening combined with tight liquidity have had an effect, with inflation still high at 7.48% in November but trending downwards in Asia’s third-largest economy.

“To sum up, the underlying growth momentum of the Indian economy remains strong. Even as inflation has moderated, it remains significantly above the comfort level of the Reserve Bank," the RBI said in a statement.

The central bank’s perceived comfort level for inflation is 5-6%.

Commodity Price Concerns

While the central bank has forecast the wholesale price index (WPI), the main inflation measure used in India, will ease to 5.5% by the end of the fiscal year in March, rising global commodity and energy prices pose upward risks.

Inflationary worries are spreading globally. China’s annual headline inflation reached 5.1% for November, a 28-month high and, putting pressure on Beijing to tighten monetary policy.

“There is a risk that rising international commodity prices will spill over into domestic inflation. Going forward, rising domestic input costs for the manufacturing sector combined with aggregate demand pressures could weigh on domestic inflation," the Indian central bank said in a statement.

Liquidity Tap

India’s financial system has been squeezed by unusually tight liquidity conditions since November, with banks forced to borrow and average of 1 trillion a day from the RBI, crimping their ability to lend and acting as an inflation-fighting tool.

The announcement on bond buybacks gives investors confidence that the RBI intends to inject liquidity into the system even as the goverment continues with its bond issuance programme.

Trimming SLR gives banks more flexibility to borrow from the RBI and fund short-term operations.

“RBI wants to address liquidity first and then get on to hiking rates. After these measures, we expect liquidity to come back to comfortable zones by January," said Ananth Narayan G, head of fixed income, currencies, commodities for South Asia at Standard Chartered in Mumbai.

“Earlier we were expecting liquidity to do the job for RBI and they wouldn’t need to hike rates in January, but now it seems if inflation remains high, RBI may hike rates in January," he said.

The 1-year OIS fell as much as 12 basis points after the policy review, or 21 basis points below a 26-month high reached on 8 Dec. The yield on the benchmark 10-year bond also fell as much as 12 basis points to 7.95%, its lowest since 4 Nov.

As expected, the central bank left the repo rate , at which it lends to banks, unchanged at 6.25% and also kept the reverse repo rate , at which it absorbs excess cash, on hold at 5.25%.

The RBI left the cash reserve ratio (CRR) , or the portion of deposits banks need to set aside as cash with the central bank, unchanged at 6%.

Indian oil retailers raised petrol prices by 5.6% this week and the government is expected to lift diesel prices soon by roughly 2 a litre, moves that together could lift WPI inflation by 30 basis points and have a knock-on effect of the same magnitude as costs are passed along, Morgan Stanley wrote.