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The inter-bank call money rate hit 70 per cent on March 21, though it cooled down a little later. Banks are prepared to pay such high rates of interest for a short time because they are mandated to maintain 6 per cent of their deposits in cash with the Reserve Bank of India and another 25 per cent in government and other approved securities. A bank would rather conform to these ratios than incur the ire of the RBI.

Most banks have used their free deposits to lend to the full extent because it is credit that makes for their profitability. With the demand for credit piling up, banks have increased the interest rate, which makes it possible for them to now pay higher interest on deposits. In the past one year the prime lending rate of banks shot up from 10.5 per cent to 12 per cent and the interest on deposits from 6.5 per cent to 9 per cent. Selectively, banks have raised rates to even  10-11 per cent under fixed maturity plans.

Interest rates have been rising not only in India but in many other countries. The increase has been engineered by central banks in response to the threat of inflation. In  the US, where inflation has been more than 2 per cent, the Federal Reserve raised up the overnight interest rate  to 5.25 per cent through 17 successive increases; in the EU, where inflation is less than 2 per cent, the European Central Bank rate, after seven increases, in now at 3.75 per cent. It appears that these rates have reached their peaks and, before the economies slow down, will be reversed, possibly in the second half of 2007.

The softening of interest rates in the international markets would, to some extent, ease pressure on Indian banks. But it is the demand for credit that will finally decide which way and how far interest rates will move. The increase in interest rates in the past year does not seem to have discouraged borrowers significantly. True, some interest-sensitive loans like home loans and car loans have lost their momentum. Even so, credit growth is still way ahead of deposit growth, and is fueling inflation.

Obviously, the interest rate impacts inflation only with a time lag. It took the Federal Reserve two years and the ECB 15 months to defuse inflationary pressures. Even then, neither seems to be convinced that the economies are stable. The RBI measures, similarly, will take time to show results. When production cannot be commensurately increased, producers easily pass the higher cost of credit on to consumers.

If, however, the monsoon turns out to be favourable, there is a good chance that agricultural production will increase and inflation will ease. In that case, the earliest the interest rates will be reversed will be in October. But with inflation currently higher than the RBI benchmark, it is possible that in the April policy review interest rates may actually be driven up further.