By Suvashree Dey Choudhury and Tony Munroe
MUMBAI (Reuters) - The Reserve Bank of India raised interest rates for the second time in as many months on Tuesday, warning that inflation is likely to remain elevated despite sluggish growth, and rolled back an emergency measure put in place in July to support the rupee.
Facing some of the fiercest price pressures in Asia, the RBI lifted its policy repo rate by 25 basis points (bps) to 7.75 percent, in line with expectations in a Reuters poll.
"Overall WPI (wholesale price index) inflation is expected to remain higher than current levels through most of the remaining part of the year, warranting an appropriate policy response," RBI Governor Raghuram Rajan said. He later said the RBI's next rate move would not necessarily be upwards.
While some RBI watchers say he may not yet be finished tightening, markets took comfort that Rajan's tone wasn't more hawkish and bond yields saw their biggest drop in three weeks.
"You should not see the fight against inflation as anti-growth. It is going to be the best medicine for sustainable growth going forward," Rajan told a media briefing.
In last week's Reuters poll, the median expectation was for no further policy moves in upcoming reviews.
With the rupee having stabilised after a steep May-August slide, the RBI also lowered its Marginal Standing Facility (MSF) rate by a further 25 bps to 8.75 percent, as expected, which eases liquidity in the banking system by lowering the cost of borrowing for lenders.
Rajan, a high-profile former chief economist at the International Monetary Fund, took office in early September and stunned markets in his first monetary policy review just weeks later by raising interest rates to combat price pressures dogging Asia's third-largest economy.
"Today's move was a follow-through of the hawkish September policy guidance, as high and persistent inflation is seen as an impediment to the medium-term growth outlook," said Radhika Rao, economist at DBS in Singapore.
India's benchmark 10-year bond yield dropped as much as 12 bps to 8.54 percent, as traders were relieved that the rate hike was accompanied by an MSF cut. The rupee erased all losses to gain on the day to 61.31/32 per dollar while stocks rose nearly 2 percent.
"Yields dropped because he has shown equal concern about growth and said that RBI doesn't want only to focus on inflation," said Harish Agarwal, a fixed income trader with First Rand Bank.
For graphic on India WPI, rates, industrial output, click http://link.reuters.com/deq95s
For graphic on India economy, click http://link.reuters.com/fuh42v
For Reuters policy web page, click http://in.reuters.com/subjects/rbi-policy-review
Video: RBI's rate hikes: Room for more?: http://link.reuters.com/kyd34v
FOOD FIGHT
India's annual food inflation accelerated to 18.4 percent in September, its highest since mid-2010, pushed up by prices of vegetables including onions and stirring public discontent ahead of national elections which must be held by next May.
However, the economy grew at just 4.4 percent in the June quarter, its slowest since early 2009. The 5 percent growth rate recorded in the last fiscal year through March was the weakest in a decade.
The RBI expects the economy to grow 5 percent again in the current fiscal year that ends in March, below its earlier forecast of around 5.5 percent but still above many private-sector forecasts.
"The pass-through of rupee depreciation into prices of manufactured products is acting, along with elevated food and fuel inflation, to offset possible disinflationary effects of low growth," Rajan said in his policy statement.
The headline wholesale price index unexpectedly hit a seven-month high in September of 6.46 percent as food prices surged -- well above the RBI's perceived comfort level of around 5 percent -- while the consumer price index jumped an annual 9.84 percent.
The RBI said on Tuesday CPI inflation would remain above 9 percent in coming months "absent policy action."
D.K. Joshi, principal economist at Crisil Ltd in Mumbai, said future rate moves would depend on inflation readings.
"If inflation surprises on the lower side, then you should see RBI holding. Otherwise, with this inflation trajectory, I think they will raise rates," he said.
The rupee slumped to record lows in August, at one point sliding some 20 percent for the year, on concerns about India's gaping current account and fiscal deficits, and as global investors dumped emerging market assets for fear the U.S. Federal Reserve was set to start tapering its massive stimulus programme.
To halt the slide, the RBI had jacked up the MSF rate by 200 bps in July. It rolled back 75 bps of that at its September 20 review and another 50 bps earlier this month.
Tuesday's cut returns the gap between the repo and MSF rates to the usual 100 basis points.
(Additional reporting by Swati Bhat, Neha Dasgupta, Himank Sharma and Subhadip Sircar; Editing by Kim Coghill)
