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NEW DELHI (Reuters) - Rising fuel prices boosted inflation in September to 7.8 percent, its highest level since November, undermining the government's case for an interest rate cut by the RBI this month to boost the sluggish economy.
The rise in the wholesale price index - India's main inflation gauge - was more than expected. Economists in a Reuters poll had expected an inflation reading of 7.7 percent, up from 7.55 in August.
The Reserve Bank of India (RBI) has held its policy rate at 8 percent since April, even though economic growth is at its weakest in three years, saying stubbornly high inflation prevents it from cutting borrowing costs. Inflation is well above the central bank's comfort level of 4-5 percent.
"Today's inflation number significantly reduces the chance of a repo rate cut in the next policy (review)," said Jyotinder Kaur, economist at HDFC Bank in New Delhi. "But we see the Reserve Bank of India reciprocating to the government's recent reform measures by yet again cutting bank's cash reserve ratio."
Financial markets were muted in their response to the data. However, the 5-year and 1-year swap rates both rose 2 basis points, suggesting traders believe the prospects of a rate cut have receded slightly.
GRAPHIC-Output, rates, WPI: link.reuters.com/deq95s
Faced with a big hole in the budget and the prospect of losing its investment grade credit rating, the Indian government increased the price of heavily subsidised diesel on September 13.
Monday's data showed that fuel prices in September rose 11.9 percent from a year earlier, a sharp pick-up compared with a rise of 8.32 percent in August.
"The inflation number is very ugly," said Rupa Rege Nitsure, the chief economist of Bank of Baroda in Mumbai. "Overall the inflation situation is going to worsen until end-December."
Nitsure said she expected the central bank to keep rates on hold until the fourth quarter of the fiscal year to next March. However, given weak growth, she expected the central bank to ease the amount it requires banks to hold as reserves - which frees up more cash for lending - at its policy meeting on October 30.
The RBI cut the cash reserve ratio in September by 25 basis points to 4.5 percent in a move to inject about 170 billion rupees into the banking system.
Analysts expect inflation to quicken more in the coming months because fuel and food make up more than a third of the wholesale price index, but one of the government's top economic policy advisers played down such concerns.
"It is true that when you raise a key price like diesel, in the short run you have an uptick, but the idea that six months later the inflationary situation will be worse as a result of this is not true," Montek Singh Ahluwalia, deputy chairman of India's planning commission, said in Mumbai.
A few economists think WPI inflation will fall, arguing that weak demand will offset fuel price pressures.
The data also showed a modest pick-up in manufacturing inflation to 6.26 percent in September from 6.14 percent in August. Food inflation, meanwhile, slipped to 7.86 percent in September from 9.14 percent a month ago following a moderation in vegetable prices.
Finance ministry officials have said recent fiscal reforms have given the RBI room to cut interest rates by at least 25 basis points, and Finance Minister P. Chidambaram gave the RBI a further prod in an interview with Reuters on Saturday, when he called for it to take "calibrated risks" to support the economy.
"Pressure is mounting on the central bank for a quid-pro-quo move after the government initiated reforms to correct the fiscal imbalances and we expect consensus to be split as we approach the end-Oct review," said Radhika Rao, economist at Forecast Pte in Singapore.
But the response to the global economic slowdown could keep the RBI on a tight leash. Massive asset purchase programmes by central banks in the United States, Europe and Japan could stoke global commodity prices and keep domestic prices on the boil.
Despite the inflationary pressures, some analysts refuse to rule out a surprise rate cut as a reward for the government's moves to raise the prices of diesel and fertiliser.
With barely 18 months until the next general election, Prime Minister Manmohan Singh is trying hard to get the economy back on track, partly to fund big-ticket welfare programmes.
As well as increasing fuel prices, in the last few weeks he has opened up the retail sector to global supermarkets, allowed foreign airlines to buy stakes in local carriers and proposed raising the bar on foreign direct investment in insurance firms.
But that may not be enough to rescue an economy a government panel recently said was teetering at a fiscal precipice.
Inflation has been above 7 percent in each month since late 2009. And still-high spending on fuel, food and fertiliser subsidies could drive the fiscal deficit to 6 percent of GDP for the financial year ending in March, above New Delhi's target of 5.1 percent, Standard & Poor's said last week.
Additional reporting by Mumbai treasury team; Editing by Frank Jack Daniel and Alex Richardson