"The monetary policy would place equal emphasis on price stability and on supporting investment demand"
Y V Reddy in April

"There are no unexpected circumstances that have occurred since the [last] monetary policy statement to warrant a review of rates."
Y V Reddy in June

Which way will Reserve Bank of India [Get Quote] Governor Yaga Venugopal Reddy turn? In April this year, while outlining the stance of the policy, he hiked the short-term reverse repo rate by 25 basis points (one basis point is one hundredth of a percentage point).

But just last month, he's given the impression that there will not be any rate hike on July 26 when the Indian central bank announces its first quarterly review of the monetary policy.

In the US, which many see as a signal of how things will move in India, bond dealers are fighting the Federal Reserve. Despite a nine-stage quarter percentage point hike in the US Fed rate between June 2004 and now -- from 1 per cent to 3.25 per cent -- the 10-year US Treasury yield has not been going up.

On June 29, 2004, the day before the US Fed effected the first dose of hike in its base rate to 1.25 per cent, the 10-year treasury yield was 4.70 per cent.

On June 30 this year, when the Fed jacked up the rate to 3.25 per cent, the 10-year US Treasury yield actually fell by 5 basis points to 3.94 per cent. Subsequently, it has gone up to over 4 per cent.

While Federal Reserve chairman Greenspan has taken an aggressive approach in raising rates, the bond dealers on Wall Street seem to be feeling that the economy is slowing down and the inflation rate is no more a threat.

This rate "conundrum" is also applicable to the Indian context even though it may not be as sharply evident as in the US.

Here, the market is not challenging the Reserve Bank's policy signal as aggressively but the long-term rates have not been going up significantly despite the central bank's nudges.

In early October last year when the reverse repo rate was pegged at 4.50 per cent, the 10-year government bond yield was veering around 6.70 per cent.

Since then, it has gone up by around 50 basis points, an identical margin by which the reverse repo rate has been hiked in two stages -- in October last year and April this year.

In normal circumstances, it should have gone up by much more.

Most of the bonds dealers are pricing in a quarter percentage point hike in short-term rates. This is essential, they say, to engineer a soft landing for domestic demand and to keep inflation expectations in check.

The yield curve has steepened with the spread between the one-year and 10-year bond widening, indicating long-term inflationary expectations.

However, there are equally strong arguments against any rate hike at this point. First, let's take a close look at the factors that may prompt the governor to go for a rate hike.

At the top of the list is the rising oil prices. Global oil prices are a fifth higher in comparison with their end-April level, which is when the RBI hiked the short-term rate.

Fuel accounts for over 14 per cent of the wholesale price index-based inflation. Every one-dollar rise in crude prices translates into a 30 basis points hike in WPI-inflation, which is around 4 per cent now -- while this is down from 5 per cent in April, it will rise once the base effect wears off and domestic demand pressure intensifies.

In fact, the inflation rate can go up to around 6 per cent by the end of fiscal year 2005-06, a research report by a foreign bank says.

Industrial growth has risen sharply to 10.8 per cent in May, up from 8.5 per cent for the last one year. Little surprise then, that the credit offtake in the banking system has hit historic highs.

On a year-on-year basis, the credit portfolio of the system has grown by over 32 per cent, far higher than the RBI's estimate of 19 per cent, and the highest in several decades.

However, there are equally strong reasons why Reddy should refrain from such a move at this juncture. Even though the rising global oil price is a major worry, this may not be too much of a problem if the government does not hike local oil prices, as seems likely.

In any case, in the near term, inflation is expected to fall on account of the statistical base effect before rising its head around October.

Finally, there are still uncertainties surrounding the monsoon, which plays a key role in the demand surge. These factors may prompt Reddy to say no to the market expectations.