The Reserve Bank of India stepped in to do its bit towards reining in inflation.

In an indirect admission that inflation is not a supply-side problem, the monetary authority decided to lower liquidity in the system by raising the cash reserve ratio requirement for banks by half a percentage point to 5%.

Significantly, RBI has also said that it will now pay only 3.5% on CRR deposits that banks keep with it, as against 6% till now - a move that could force banks to lend more.

The CRR hike, which comes on the back of four weeks of 7% plus in-flation, will be effective in two stages. With effect from September 18, the CRR will be 4.75% and then 5% from October 2. Till now efforts to contain inflation were restricted to duty cuts.

CRR is the money that banks are required to maintain by regulation as cash deposits with RBI. The amount that each bank has to deposit is determined as a percentage of deposits raised by that bank. An increase in the CRR percentage results in a reduction of funds available for lending.

Meanwhile, the bond market reacted negatively as prices of government securities fell by a rupee.

Although the hike will take out close to Rs 8,000 cr from the banking system, it will still leave with more than enough cash.

Going by the amount banks have lent to RBI by way of repo, the surplus fund is in the region of Rs 40,000 cr. The real impact on banks will be the Rs 1,788 crore loss of interest income following the reduction of interest rate on cash reserves.

Home loan rates are unlikely to be move in reaction to the CRR. "We have no plans to increase rates as the CRR hike affects only banks," said Keki Mistry, managing director, HDFC.

SBI chairman AKPurwar said the bank will not immediately hike interest rates. The second big-gest player, ICICI Bank said there are no immediate plans to raise rates, but will watch the market next week.

"The hike should not have an impact on liquidity since the surplus funds with banks is in the re-gion of Rs 80,000 crore. But we will be watching the situation in the money markets next weeks," said Chanda Kochhar, executive direc-tor, ICICI Bank.

According to Pradeep Madhav, executive vice-president of the bond house IDBI Capital, a lower interest of 3.5% on the CRR balance is also an indication that the repo rate will not be hiked immediately.

"Due to a lower return banks will be forced to lend more aggressively to preserve their spreads," he said.

By resorting to a blunt monetary instrument of CRR, RBI is in a way harking to the past. Around five years ago, RBI had decided to aban-don direct measurers such as CRR to impound liquidity and resort to indirect measures such as open market operations and revision of key interest rates to conduct its monetary policy.

But given the circumstances, a hike in CRR and simultaneous reduc-tion of interest rates enables RBI to achieve all three objectives of re-ducing liquidity, protecting RBI's balance sheet and stabilising interest rates in the money markets.

As a monetary authority, RBI's responsibility includes releasing enough cash to fund growth and absorbing surplus cash when there is a danger of liquidity fuelling inflation. The central bank also has to en-sure that interest and foreign exchange rates do not fluctuate wildly.

RBI can do this in three ways: one by selling or buying government bonds to absorb or infuse liquidity, secondly by varying the repo rate or the Bank Rate -- the rates at which banks lend and borrow from RBI respectively, and finally by adjusting reserve requirements.

RBI's ability to conduct open market operations are restricted since it has run out of government securities. To make up for this, RBI has asked the government to impound money by borrowing through issue of market stabilisation bonds.