By Suvashree Dey Choudhury and Tony Munroe
MUMBAI (Reuters) - The RBI surprisingly raised interest rates on Tuesday to dampen inflation, saying it was now better prepared to deal with the risk of major capital outflows roiling emerging economies.
The Reserve Bank of India (RBI), however, said that if retail inflation eases as projected, it does not foresee further near-term monetary policy tightening.
The rupee sank 11 percent last year as emerging markets sold off sharply after the U.S. central bank announced it would taper its aggressive bond-buying programme that had fuelled global demand for risk assets.
Expectations the Federal Reserve will further scale back stimulus this week have renewed pressure on emerging economies although the rupee has fared better than other currencies this time. Turkey's central bank was expected to raise rates to defend the lira at an emergency meeting later on Tuesday.
The 25-basis-point rate hike was driven by expectations of high but moderating consumer price index (CPI) inflation, an indication the central bank intends to adopt a recent proposal to base its rate decisions on a CPI target.
RBI Governor Raghuram Rajan faces the daunting challenge of reviving an economy growing at its slowest in a decade while battling stubbornly rising prices, especially for food, fuelled by supply-side shortages beyond the control of monetary policy.
HSBC economist Leif Eskesen expects more rate increases from the RBI.
"This was the right decision, but it does not constitute the end to the tightening cycle, in our view. If RBI wants to knock out core inflation, the policy rate will likely have to be hiked further."
The RBI raised its policy repo rate to 8.00 percent amid market worries over slowing growth in China and the prospect of further tapering of U.S. stimulus.
"We have injected some medicine, 75 bps in rate hikes since September, and we have to watch to see how that medicine works along with, again, the weak state of the economy as well as the stabilisation of the rupee," Rajan told a news briefing.
Lifting rates lends support to an Indian currency which strengthened slightly on Tuesday.
The Indian economy, which not long ago aspired to double-digit growth, has been weakened by sluggish investment and persistent inflation in recent years under the corruption-scandal battered Congress party government of Manmohan Singh, which faces an uphill battle in elections due by May.
Most economists in a Reuters poll last week had expected no change in rates. However, expectations for a rate hike had increased after a central bank panel proposed to make CPI the main inflation benchmark.
"For now, this should mark the peak of the rate hike cycle, with the central bank's growth projections close to our conservative estimates," said Radhika Rao, economist at DBS Bank in Singapore.
The RBI said economic growth was likely to fall short of its earlier projection of 5 percent this fiscal year and improve to 5-6 percent in the year that starts in April.
The CPI eased to a three-month low of 9.87 percent in December, well above the wholesale price index (WPI), long the RBI's main price barometer, which slowed to 6.16 percent in December.
Indian bonds, stocks and the rupee fell after the rate increase but recovered most losses due to a statement seen as dovish, although the RBI said that consumer inflation risks remain to the upside.
The benchmark 10-year bond yield rose as much as 13 basis points after the hike before retreating.
For graphic on WPI, CPI, click http://link.reuters.com/zar28t
For graphic on rates and factor output, click http://link.reuters.com/deq95s
Full coverage of RBI monetary policy http://in.reuters.com/subjects/rbi-policy-review
POLICY REVAMP
Last week, a central bank panel proposed revamping its policymaking structure by setting a long-term CPI inflation target of 4 percent, plus or minus 2 percent. In the intermediate term, the goal would be to trim CPI to 8 percent by January 2015 and 6 percent by January 2016.
"An increase in the policy rate...will set the economy securely on the recommended disinflationary path," the RBI said.
"If the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture," it said.
Rajan, who took office in early September, adopted the panel's recommendation to review monetary policy every two months. It had been reviewing policy eight times a year.
The RBI said CPI inflation was likely to stay above 9 percent during the final quarter of the fiscal year that ends in March, ranging between 7.5 percent and 8.5 percent for the quarter that ends in March 2015, "with the balance of risks tilted on the upside."
(Additional reporting by Swati Bhat, Neha Dasgupta and Subhadip Sircar; Editing by Jacqueline Wong)
