The Reserve Bank of India (RBI) appears set to begin tightening money supply, judged

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by its warning on Thursday, the eve of the credit policy review -- that stronger recovery could result in high food inflation spilling over to the manufacturing sector as well.

“The emerging growth and inflation mix suggests that a stronger recovery could make inflation a more generalised process,” RBI said in its macro-economic outlook released a day before it reviews its policy on the extent of money supply and the cost at which it would be made available.

The outlook for growth has upside prospects with several supportive developments under way. The outlook for inflation is characterised by developments that have upside risks, RBI said. “Reining in inflation and inflationary expectations while carefully nurturing growth impulses will be the main challenge for the conduct of the monetary policy during the remaining period of the year.”

“Durable goods prices and core inflation are on a clear uptrend. We believe the rise in manufactured goods prices is strong enough to offset declines in food prices,” said Rahul Bajoria, economist with the UK-based investment bank, Barclays Capital.

Barclays expects RBI to increase the proportion of deposits banks are required to set aside as cash reserves by 50 basis points to 5.5 per cent. “In addition, we also expect a token 25 basis point hike in the rates at which banks park their money with RBI and at which it lends money to banks. However, the probability of this happening is lower than that of an increase cash reserve ratio,” Bajoria said.

Currently, RBI lends money to banks at 4.75 per cent. The rate at which banks park their funds with it is 3.25 per cent.

A 50 basis point hike in cash reserve requirement will result in about Rs 16,000 crore of liquidity being drained from the banking system.

CARE Ratings, in a note, said RBI could hike the rate banks park their funds with it as an incentive to them to further part with excess liquidity.

RBI said that though inflationary process still remains largely concentrated in food articles, there was a possibility of a gradual spilling over of the pressure to other segments in the basket of goods in the wholesale price index basket. Early signs of this were evident last month.

The outlook for inflation will be conditioned by the upside risks like the persistence of supply side pressures in the near term, a possible return of pricing power with a stronger recovery in growth, a further revival in private demand, a possible spurt in global commodity prices and the possibility of high inflation in consumer prices and food prices spilling over to other areas.

The growth and inflation mix for India, thus, is increasingly becoming asymmetric in relation to other countries in the G-20 group. The possibility of surges in capital inflows and the associated domestic liquidity conditions may also affect inflationary expectations, besides the impact of a rebound in international commodity prices in response to global recovery.

The growth outlook has improved significantly since the release of GDP data for the second quarter of 2009-10 and the strong industrial recovery in recent months. Inflationary pressures have firmed up, led by significant increases in food prices. “Thus, growth outlook has clear upside prospects and inflation outlook has upside risks,” RBI said.