MUMBAI (Reuters) – The Reserve Bank of India stunned investors by raising interest rates 50 basis points, showing unexpected resolve in fighting persistently high inflation despite slowing growth in Asia's third-largest economy and uncertain global demand.
The RBI on Tuesday increased the repo rate at which it lends to banks to 8 percent, topping all 23 forecasts in a Reuters poll that it would raise rates by 25 basis points, and indicated it will continue with its anti-inflationary stance.
The rate rise was the RBI's 11th since March 2010 and sent bond yields and swap rates sharply higher and stocks lower.
Investors and industry officials who had expected the central bank to be nearing the end of its tightening cycle were caught off guard, with some observers criticising the RBI for acting too aggressively or too late.
A snap poll after the rate move found six of 11 economists expect the repo rate to end 2011 at 8.50 percent, or 50 basis points higher than in a poll last week.
"Quite a surprise. Clearly they are quite worried about inflation and the risk is they don't stop with this rate hike," said Ramya Suryanarayanan, economist at DBS Bank in Singapore.
"We think further rate hikes are going to slow growth considerably, below the RBI's forecast of 8 percent. Our forecast is 7.5 percent and such persistent rate hikes point to further downside risk to growth," she said.
Headline wholesale price index inflation was 9.44 percent in June, more than double the central bank's comfort level, and prices are expected to stay high in coming months.
"Considering the overall growth and inflation scenario, there is a need to persevere with the anti-inflationary stance," RBI Governor Duvvuri Subbarao said.
"A change in stance will be motivated by signs of a sustainable downturn in inflation," he said.
With 250 basis points of tightening over the past year, India is easily the most aggressive inflation fighter in the world, surpassing even Brazil.
The one-year swap rate jumped as much as 27 basis points to 8.25 percent after the rate decision, while the benchmark five-year swap rate rose 13 basis points to 7.71 percent, further inverting the yield curve in a sign that investors are worried about slowing growth.
Manoj Swain, chief executive at Morgan Stanley Primary Dealership, said a one-year swap rate below 8.50 percent indicates the market is still not pricing in further rate increases.
India's benchmark 10-year bond yield rose as much as 12 basis points to 8.44 percent after the policy decision, while stocks lost 1.87 percent after starting the day in positive territory.
The central bank, whose forecasts for inflation have proven optimistic in recent quarters, raised its estimate for wholesale prices inflation at the end of the fiscal year in March to 7 percent, from 6 percent earlier.
The RBI retained its forecast for economic growth in the current fiscal year of around 8 percent.
While some interest-rate sensitive sectors are showing signs of moderating growth, it said, "there is no evidence of a sharp or broad-based slowdown as yet."
Tuesday's half-point rate rise is the second since May for the RBI, which had leaned towards 25 basis point rises and had been criticised for lacking vigilance in fighting inflation.
The RBI warned that high non-food manufacturing inflation and upside risks to food prices after a rise in government-set prices could keep broader inflation high in coming months.
"The RBI remains very wary of a wage-price spiral risk given that wage gains have been strong," said Vishnu Varathan, economist at Capital Economics in Singapore.
Despite the steady rise in policy rates, real lending rates in India are nearly flat, giving the RBI more room to tighten. The one-year corporate loan rate is roughly 9.5-10 percent, nearly in line with headline inflation.
"This is unfortunate," Sunil Sikka, president of electrical parts maker Havells India, said after the rate rise. "We thought 25 basis points could be okay. But they have not been able to tackle inflation so far," he said.
Recent industrial output and manufacturing data was the worst in nine months, while sales of cars have slowed sharply and loan demand is easing, which had added to expectations the central bank was coming to the end of its tightening cycle.
"The central bank reaction at this juncture appears far too hawkish for us," Barclays Capital wrote in a note, and said it now expects another 25 basis point increase in September.
January-March quarter growth was a worse-than-expected 7.8 percent, with economists expecting India to grow at 7.9 percent in the fiscal year that began in April, according to a Reuters poll, less than the 8.5 percent growth in the fiscal year that ended in March.
Subbarao said Tuesday's policy actions are expected to "maintain the credibility of the commitment of monetary policy to controlling inflation."
They are also expected to "reinforce the point that in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required," Subbarao said.
Inflation in India has been fuelled in part by structural bottlenecks in agriculture and infrastructure, as well as heavy government borrowing and spending on subsidies.
The governor made clear that the absence of reforms and fiscal steps to ease the supply-side constraints on food and commodities, the central bank had no choice but to keep monetary policy tight.
"In my opinion, RBI solely faces the burden of anchoring inflationary expectations, with near-absent support from fiscal levers," said Radhika Rao, an economist with Forecast Pte in Singapore.
"Fighting the inflation-battle with fractured armour is likely to limit the effectiveness of the policy action, and thereby justifies the need to remain ultra-hawkish."
(Additional reporting by Swati Bhat, Neha D'Silva, Aditya Phatak, Shamik Paul, Archana Narayanan and Subhadip Sircar; editing by Vidya Ranganathan)
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