Government bonds fell on Monday amid fears of sharper-than-expected monetary tightening by the Reserve Bank of India in its third-quarter review of monetary policy next week.

The market has so far factored in a 25-basis point increase in key policy rates after the sharp dip in November's industrial production figures.

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The index of industrial production grew by a meagre 2.7 per cent -- the lowest in 18 months.

But RBI Governor D Subbarao said on Monday that India is facing a surge in inflation and that the central bank is 'desperate' to control it.

He also said that the central bank has to calibrate its policy to manage the price rise while also supporting economic recovery.

"A lot of other countries are still flirting with deflation. . . still concerned that they might have deflation. On the other hand, we have surging inflation," Subbarao told a group of students at the Indira Gandhi Institute of Development Research.

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"When I meet other central bank governors they tell me: Why don't you give us a bit of your inflation? That's how desperately they want some inflation and how desperate we are to control our own inflation," Subbarao said.

"We have recovered from the crisis sooner than other countries, but inflation also caught up sooner."

Soon after the governor's statement, the most-traded 8.08 per cent 2022 bond ended at Rs 98.90, down from Friday's close of Rs 99.18, while the second-highest traded 8.13 per cent 2022 bond fell to Rs 99.40 from Rs 99.54.

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Many dealers said the governor's comments raise expectations of a 50-bp hike in policy rates.

A Prasanna, senior vice-president, ICICI Securities Primary Dealership, said concern has been mounting since the spike in December inflation figures were announced last week.

"So, it looks like there will be more tightening in the upcoming policy review. But to achieve a balance between supporting growth and controlling inflation, I think policy rates will be hiked by 25 basis points, keeping CRR and SLR unchanged," Prasanna added.

Headline inflation, based on the wholesale price index, rose to 8.43 per cent in December, from 7.48 per cent in November, mainly fuelled by food prices.

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Though supply-side pressures have impacted food prices more, the central bank is concerned this could lead to more generalised inflation. RBI has projected 5.5 per cent inflation for March.

The governor said the country's economic recovery is becoming more broad-based, and that RBI has to maintain a calibrated monetary policy, balancing inflation management and recovery support.

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"On the other hand, there is recovery.

"It is getting broad-based, but we have to be concerned with supportive recovery. So, for the Reserve Bank, the challenge is to calibrate monetary policy, taking into account the demands of inflation management and the demands of supportive recovery," he said.

Lenders, however, said further policy tightening may not lead to an immediate increase in lending rates.

"The Street expects a 25-bp hike in policy rates. Whether banks will pass on the hike to customers will depend on how they are managing liabilities, how they are able to increase their current and savings account deposits," said Somnath Sengupta, executive director and chief financial officer at Axis Bank.