The Reserve Bank of India, in the first mid-quarterly review of the year, under the Liquidity Adjustment Facility (LAF), raised its key short-term lending rate by 25 basis points and borrowing rate by 50 basis points. The repo rate thus becomes 6% while the reverse repo rate becomes 5%. SLR and Bank Rate remain unchanged. New rates come into effect immediately.

The move, as indicated by the central bank, will help:

1. contain inflation, currently hovering around 8.5%, and anchor inflationary expectations such that growth is not disrupted
2. reduce volatility in call money market, thereby strengthening monetary transmission mechanism
3. keep going the process of normalization of monetary policy instruments.

"Inflation remains the dominant concern in macroeconomic management," RBI said while announcing the change.

Higher rates will make availability of funds costlier for banks, leading to more expensive loans and lower consumption. Real interest rates, an area of concern for RBI, had been running negative since a long time now causing declaration in growth rate of bank deposits because people had started looking for higher return alternatives. Liquidity situation after the first review had worsened. The move makes bank deposits attractive which now will earn better returns. At the same time, through taming inflation, it is expected to boost commercial lending.

FICCI, the industry chamber expressed concern that business might be hit as a result of rate hike. PHD Chamber said, "This will adversely impact the cost of borrowing by the industry from the banks, especially by the SMEs. It may also increase the cost of home loan as well as consumer loans."

India has about 2.6 crore micro, small and medium sized enterprises, together contributing about 45% to country’s manufacturing output and 40% to exports. With a sluggish international market and lower competitiveness in the domestic market, Indian SMEs might end up in troubled waters.

India’s industrial growth went up by 13.8 percent in July, as against 7.1 percent in the previous month with major contribution from capital goods, a 63-percent jump in output, indicating higher demand conditions to prevail in coming months. This implies higher import demand, widening current account deficit and worsened balance of payments situation. It will affect exchange rates also, reducing the competitiveness of Indian enterprises in international markets. Globally, over past few weeks, investor sentiments have improved leading to steady increase in capital flows from advanced economies. If this momentum is sustained, concerns on balance of payments front will not prevail.

Reserve Bank’s Q1 Review of Monetary Policy on July 27, 2010 had shown signs slower global economic recovery in the second half of 2010 than the first, although expectations have generally not been revised downwards since end-July. The European Central Bank has revised its forecast for second-half growth upwards. China’s, industrial production and trade numbers have shown sign of revival, after showing sluggishness in the second quarter of 2010. Still, at a time when the wheel of economic growth is not spinning too fast, such a move can dampen the momentum. Inflation rate and global recovery will decide the future course of action of the Central Bank.