The BSE Sensex rallied 2.2 percent on Tuesday to its highest close in a month, on expectations easing inflation pressure will pave the way for the RBI to begin unwinding tight monetary policy this month.

Financials such as ICICI Bank and State Bank of India and engineering and construction conglomerate Larsen & Toubro were among the gainers in anticipation of a pick-up in business activity.

Energy major Reliance Industries, whose earnings are driven by refining margins, rose 4.2 percent to its highest close in nearly two weeks.

The Reserve Bank of India RBI.L, which raised interest rates 13 times between early 2010 and last October, is expected to cut the proportion of deposits that banks keep with the central bank from 6 percent currently, traders said.

The market was in an oversold zone, said Jagannadham Thunuguntla, head of research, SMC Investments and Advisors Limited. Value picking was seen today ... hope is also increasing that the RBI will cut rates going ahead.

The 30-share BSE index rose 2.22 percent, or 350.37 points, to 16,165.09, its highest close since December 8. All but two of its components rose. The benchmark had slumped almost a quarter in 2011.

Kishor P Ostwal, charman and managing director of CNI Research, said December headline inflation is likely to drop below 8 percent on the back of a fall in the food price index.

State Bank of India, the country's largest lender, rose 4 percent, while rival ICICI Bank rose 3.6 percent. Larsen & Toubro climbed 4.2 percent.

Utility vehicle and tractor maker Mahindra and Mahindra (MAHM.NS) rose 5.5 percent and truck and car producer Tata Motors (TAMO.NS) firmed 2.2 percent after the auto industry body forecast commercial vehicle sales to grow 18-20 percent in 2011/12.

Sentiment was helped after a finance ministry official said Moody's Investors Service has upgraded the short-term ceiling on foreign currency bank deposits.

Royal Bank of Scotland said in a note on Tuesday it is bullish on Indian shares because of their valuations, while a cut in interest rates and government action should help spur economic growth.

It expects the MSCI India index to rise a quarter in 2012.

The bank said it liked rate-sensitive sectors such as financials, but was underweight on telcos due to deteriorating regulatory and competitive environment.

Deutsche Bank forecast the BSE index could reach 18,000 by the end of 2012, up about 14 percent from Monday's close.

It said banks, real estate and infrastructure would be the key drivers in 2012 and its top picks included Axis Bank (AXBK.NS), ICICI Bank, Coal India (COAL.NS), Larsen and Toubro, Tata Consultancy, Bharti (BRTI.NS) and DLF (DLF.NS).

Software bellwether Infosys (INFY.NS), which kicks off the earnings season on Thursday, ended 0.95 percent higher.

The 50-share NSE index ended up 2.25 percent at 4,849.55. In the broader market, there were nearly 5 gainers for every loser on volume of 722 million shares.

STOCKS THAT MOVED

* IndusInd Bank (INBK.NS) closed up 6.2 percent after it reported in 34 percent jump in October-December earnings.

* Construction firm IRB Infrastructure Developers (IRBI.NS) surged 10.3 percent after CLSA upgraded the stock to 'buy' from 'outperform' on attractive valuations.

* Industrials Alfa Laval India (ALFA.NS) jumped 14.4 percent to 2,710.30 rupees after the company said its parent had offered to delist the stock at a price of 2,850 rupees per share.

TOP 3 BY VOLUME

* DLF Ltd (DLF.NS) with 36.3 million shares

* Suzlon Energy (SUZL.NS) with 23.4 million shares

* Unitech (UNTE.NS) with 18.4 million shares