effect of impounding market liquidity on a temporary basis. thus, new factors have been impinging the assessment of liquidity in recent weeks, which has been reflected in the behaviour of overnight market rates and in the reserve bank ’ s liquidity management operations ( table 3 ). in the financial markets, the shifts in liquidity flows between the first quarter of 2007 - 08 and the preceding quarter have imparted considerable volatility. overnight rates have been close to zero for a prolonged period of time ( chart 1 ). these have been caused by the cumulative impact of the unwinding of government cash balances, excess capital flows, and high deposit growth. in the government securities market, there is reasonable stability but the yield curve seems to be indicating that excess liquidity conditions in the short term segment was beginning to effect longer term yields. the forex market is experiencing continuous upward pressures on the spot exchange rate and forward premia have declined across maturities. the most important change between april and now is in inflation conditions. it may be recalled that in january 2007, the resolve of monetary policy was stated as returning inflation to within the policy tolerance threshold on a priority basis. against the backdrop of the spike in wpi inflation in january and the persistence in the hardening of consumer prices, this stance was reinforced in april. the combination of monetary, fiscal and supply management measures appears to have had a salutary effect on inflation expectations and from end - may there has been a distinct easing of inflation in terms of the headline. yet, inflation pressures appear to be ruling firmly. excluding the decline in energy prices since february, wpi inflation continues to be above 6 per cent. excluding food and energy prices, inflation would still be above the headline. inflation in terms of consumer prices is still in the range of 5. 7 - 7. 8 per cent. besides, global prices of key food grains such as wheat and rice, and of oilseeds and livestock products are at historically elevated levels, igniting international concern on the effect of these prices on overall inflation. with food having a higher weight in price indices in developing countries, this development is of particular concern to countries such as ours. international crude prices are high and volatile with expectations that they would remain at these levels through 2007. these factors would have a definite bearing on the manner in which the inflation outlook in india evolves over the months to come. inflation concerns remain with us and thus our vigil on inflation must continue

with increasing linkages and potential vulnerability to contagion effects. in response to these developments, several monetary authorities have continued to display a readiness to tighten monetary policy further in reinforcement of their stance in april. central banks in emes have supported the withdrawal of monetary accommodation with successive increases in cash reserve requirements and in the application of non - monetary measures. in india and china, in particular, the use of cash reserve requirements has been more frequent than in other emes ( table 5 ). thus, central banks across the world remain hawkish with respect to inflation and prepared to act against any signs of instability developing. where they have paused, as in the us, they have done so on the back of sustained prior action. the outlook on inflation continues to drive the response of central banks ( table 6 ). one key issue that many of the key emerging market economies ( emes ) are facing is the issue of excess forex flows, both because of a current account surplus in most cases, and additional capital flows. in this regard, the key difference between india and most of these economies is the existence of a current account deficit, though modest, along with a significant merchandise trade deficit which is now in excess of 7 per cent of gdp. most of these countries, along with us, have experienced significant real exchange rate appreciation over the last year or two. so the practice of monetary management has encountered significant complexity in a number of emes. we are not alone. we may note that we have so far been managing this complexity relatively successfully within the context of high economic growth, high credit growth, a reasonable degree of price stability and most importantly maintenance of financial stability. the quality of bank balance sheets has been improving on a continuous basis, and we are hopeful that they will reach international best practice soon. it is interesting to observe that, just like us, many of these countries have been using the whole range of monetary instruments, including direct sterilisation through issuance of government or central bank bonds, increases in reserve requirements, and different means of capital account management to manage the monetary impact of excess forex flows. the overall problem of the capital flows, both from the point of view of the monetary management of emes and reverse capital flows to industrialised countries, is now receiving worldwide attention. the committee of global financial system ( cgfs ) under the aegis of bis has also appointed a working group to look into these complex issues. ii. macroeconomics of policy assessment domestic macro