India's central bank raised interest rates by a bigger-than-expected 50 basis points on Tuesday and declared it would battle stubbornly high inflation even at the cost of some economic slowdown, casting doubt over the government's ambitious growth targets.
The rate rise was its ninth since March 2010 and exceeded forecasts for a 25 basis point rise, although the case for stronger action had been building since figures showed March inflation reached nearly 9 percent.
The Reserve Bank of India has been among the most aggressive central banks anywhere over the past year but its gradual policy tightening has failed to cool inflation that was initially driven by high food and fuel prices, and more recently by demand pressures.
Current elevated rates of inflation pose significant risks to future growth, RBI Governor Duvvuri Subbarao said in the bank's annual monetary policy statement.
Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence, he said.
The RBI lifted its repo rate, at which it lends to banks, to 7.25 percent and said inflation will remain elevated near March levels in the first half of the fiscal year that began in April before easing in the second half.
The overnight indexed swap curve flattened, with the 1-year rate rising as much as 20 basis points, compared with an 11 basis point increase in the 5-year rate. The 10-year benchmark bond yield rose 5 basis points and traders said it could rise further.
Indian shares extended losses to 1.8 percent and the banking sector was down more than 3 percent.
The central bank's decisive action and tough language restores some of the inflation-fighting credibility it had lost while consistently underplaying inflation risks and sticking with a calibrated approach to tightening in the face of the government's pro-growth bias.
The RBI is talking more realistically about the inflation trajectory and responding a little more aggressively, said Abheek Barua, chief economist at HDFC Bank in New Delhi.
It is a more adequate action than in the past. In the long term, it will help to curb inflation, but not immediately. We are expecting another 75 basis points hike in 2011, he said.
Central banks in other developing markets have also been raising rates as their economies emerged from the global financial crisis much faster than industrialized countries. Data showing slowing manufacturing growth in China indicates that a series of policy measures by Beijing is having an effect.
Much of India's stubbornly high inflation is blamed on supply bottlenecks, including in food output, which are beyond the scope of monetary policy. However price pressures have become more widespread prompting the central bank to take more decisive action.
Inflation has consistently surprised on the upside and there is little choice but for the central bank to send a strong tightening signal/anti-inflation stance as they have done, said Ramya Suryanarayanan, economist at DBS Bank in Singapore.
Suryanarayanan predicted further 50 basis points of tightening by July.
Food price inflation of more than 9 percent and double-digit fuel price growth have added pressure on a Congress party-led government already reeling from a spate of corruption scandals.
Slower economic growth could also be a political headache for Prime Minister Manmohan Singh.
His government counts on growth of 9 percent for the current fiscal year, far in excess of most private forecasts and the central bank's new projection, to help fund increased social spending and still keep the fiscal deficit in check.
The central bank said high commodity prices and the cumulative impact of its policy measures will lead to growth of about 8 percent in the current fiscal year, assuming a normal summer monsoon and global crude oil prices of $110 a barrel.
Asia's third-largest economy grew by an estimated 8.6 percent in the year that ended in March 2011.
The central bank also rearranged its monetary policy, making the repo rate its main policy tool. From now on, the reverse repo rate, at which the RBI absorbs excess liquidity, will be pegged 100 basis points below the repo rate and adjusted in lock step with the main repo rate.
The RBI set a target of 6 percent headline inflation, with an upward bias, for the end of the fiscal year in March 2012.
Subbarao said maintaining price stability is required to sustain medium-term growth.
Persistently high rates of inflation raise the risks of inflationary expectations becoming unhinged, he said.
Analysts polled recently by Reuters had expected 75 basis points of rate increases during the remainder of 2011, including Tuesday's move.
Australia's central bank held interest rates steady at 4.75 percent on Tuesday but warned of underlying inflation that could head higher, reinforcing the case for a further tightening in the coming months.
(Additional reporting by Swati Bhat and Neha D'Silva; Editing by Tomasz Janowski)