The I-Sec report, however, acknowledges that the model is "simplistic and the constants are derived from historic data that may not be valid today". "Nevertheless, the inflation could be stoked by the money supply growth," the report says.

According to the monetary economic theory, money supply growth = Inflation (price elasticity of demand for money) + GDP growth (income elasticity of demand for money). "Assuming GDP growth of 6 per cent in an optimistic scenario), price and income elasticity of money at 1.0 and 1.5, (empirically derived data for India), the current money supply growth of 20 per cent would lead to 11 per cent inflation."

Money supply has grown at 20.1 per cent which is higher than the targeted 15 per cent to 15.5 per cent for the year.

The report, however, goes on to say that the current situation does not warrant a tightening of money supply. "Inflation, so far, is essentially a supply side problem," as the main driver of inflation at present is the price of primary articles. The price index of primary articles has risen by 14.5 per cent whereas manufactured articles' index has risen by just 5.4 per cent and fuel prices by 2.5 per cent.

"The real economy has slowed down and the optimistic estimate for industrial growth is below 6 per cent. Any squeeze on money supply at this stage comes with the inherent possibility of increasing interest rates choking a possible industrial upturn," I-Sec report states.

On various money market trends for the week ahead, the report says that call money rates are expected to move in a narrow range of 8 per cent to 8.5 per cent over this period. The treasury bill auctions are likely to continue receiving poor response because of the higher secondary yields. "With the repo rate at 8 per cent holding call rates up, the treasury bill yields are unlikely to ease, and participation will remain low unless the cut-off yields are hiked sharply".

In the secondary market for government securities, the yield curve has flattened further with two-year securities quoting at 11.4 per cent while 10-year securities are quoting at 12.27 per cent. With limited yield pick-up for longer maturities, the safe strategy is to stay in the short end, says the report. It also says that with just two to three dated security auctions pending, RBI may issue a non-standard instrument such as a floating rate bond or an inflation indexed bond.