RBI lifts interest rates, more tightening seen

Reserve Bank of India (RBI) Governor Duvvuri Subbarao attends the monetary policy review meeting in Mumbai July 27, 2010.

MUMBAI (Reuters) - The Reserve Bank of India (RBI) raised interest rates more forcefully than expected on Tuesday to fight inflation that is on track to hit double digits for a sixth straight month, setting the stage for more policy tightening.

One-year overnight interest rate swap rates jumped after the RBI notched up its fourth rate rise this year and said it was "imperative" to normalise policy in line with the economy's growth and inflation.

A clutch of Asian central banks have started to raise interest rates from the low levels reached during the world wide downturn as the region leads the global recovery.

"The dominant concern that has shaped the monetary policy stance in this review is high inflation," the central bank said, striking its most hawkish tone since the global downturn.

"With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations," it said.

The RBI lifted the repo rate , at which it lends to banks, by 25 basis points to 5.75 percent, matching forecasts. But it bumped up the reverse repo rate , used to absorb excess cash, by 50 basis points to 4.50 percent -- more than the expected quarter point.

Bond yields and swap rates rose, with the 10-year benchmark bond yield gaining 3 basis points to 7.70 percent after reaching 7.72 percent. The 1-year overnight indexed swap rate jumped 19 basis points on the day to 6.1 percent and touched 6.13 percent, its highest since late 2008.

A Reuters poll after the policy review found economists expect the central bank to lift rates more aggressively for the for the rest of the fiscal year, with most expecting a further increase in rates by the end of September.

"We think the RBI still has more work to do, and forecast the repo rate to be increased another 50 bps by the end of the year, with risks increasingly skewed to more aggressive action," said Brian Jackson, senior emerging markets strategist at Royal Bank of Canada in Hong Kong.

Graphic on the surge in interest rate swaps

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Graphic on the gap between credit and deposit growth

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Graphic on growth in reserve money

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Analysts said the RBI's moves showed it was trying to take more decisive action following criticism that it had acted too timidly so far to tackle rising prices that the authority acknowledged had spread beyond food to the broader economy.

"Of course, they are behind the curve on inflation," said Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong.

"Unfortunately, they were late to the races and this means they would have to tighten more than they would have if had they started earlier," he said.

The central bank said tight liquidity in the banking system would help transmit monetary policy into the economy. A narrower gap between the reverse repo and the repo rate would also reduce volatility in money markets and help stabilise lending rates, traders said.

INFLATION

The central bank lifted its inflation forecast for the fiscal year ending March 31 to 6 percent from a previous forecast of 5.5 percent.

It said inflationary pressures had become generalised and demand side pressures were clearly evident as an economic recovery was firmly in place. It forecast GDP would rise 8.5 percent for the year through March 2011.

Wholesale inflation, the most closely watched measure of price pressures, rose 10.55 percent in June from a year earlier.

The government's chief statistician said inflation could rise to around 11 percent in July following a government move to free up gasoline prices and raise other fuel prices.

High prices have become increasingly problematic for a Congress party-led government whose core constituency is predominantly poor and rural.

Its June 25 move to raise fuel prices prompted the opposition to call a one-day nationwide strike. Protests over food prices shut down India's parliament on Tuesday.

"Today's decision, reinforcing the unscheduled hikes on July 2nd, shows that the authorities are as much concerned about the still-untamed demand-led price pressures as they are confident about the underlying strength of the growth momentum," wrote Frederic Neumann, co-head of Asian economic research at HSBC.

He predicted another 125 basis points of tightening over the next 12 months.

The RBI promised greater transparency in its decision making, saying in the future it would hold additional policy reviews between its regular quarterly meetings.

Two of the central bank's four rate rises this year have occurred outside of scheduled meetings.

As expected, the central bank left the cash reserve ratio (CRR) unchanged at 6 percent.

(Additional reporting by Suvashree Dey Choudhury, Neha D'silva, Jeanette Rodrigues, Krittivas Mukherjee, Umesh Desai and Boby Michael)

(Editing by Surojit Gupta, Neil Fullick and Andrew Heavens)