India's central bank raised interest rates by a sharper-than-expected 50 basis points on Tuesday and signaled it would battle stubbornly high inflation even at the expense of the government's economic growth ambitions.

The rate rise was its ninth since March 2010 and exceeded expectations for a 25 basis point rise, although the case for stronger action had been building since figures showed March inflation reached nearly 9 percent, above the central bank's perceived comfort zone.

The Reserve Bank of India (RBI) lifted its repo rate, at which it lends to banks, to 7.25 percent.

Current elevated rates of inflation pose significant risks to future growth, RBI Governor Duvvuri Subbarao said in the bank's annual monetary policy statement.

Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence, he said.

The overnight indexed swap curve flattened with a sharper rise in front end rates, while the 10-year benchmark bond yield rose 4 basis points to 8.21 percent.

Indian shares extended losses to more than 1 percent and the banking sector was down 2 percent as the central bank toughened its fight to combat inflationary pressures.

The RBI has been among the most aggressive central banks anywhere over the past year. Central banks in other developing markets have also been raising rates as their economies emerged from the global financial crisis much faster than industrialized countries.

UNHINGED

But inflation in India remains stubbornly high. While supply-side bottlenecks, including in food production, are beyond the scope of monetary policy, inflation pressures have become more generalized.

Inflation has consistently surprised on the upside and there is little choice but for the central bank to send a strong tightening signal/anti-inflation stance as they have done, said Ramya Suryanarayanan, economist at DBS Bank in Singapore.

We expect a stand pat at the next meeting and then another 50 bps hike at the policy meeting in July, though it is also possible there is a 25 bps hike at the next meeting and another 25 bps hike at the July meeting.

Food price inflation of more than 9 percent and fuel price inflation in double digits have added pressure on a Congress party-led government already reeling from a spate of corruption scandals.

But lower economic growth could also be a political headache for Prime Minister Manmohan Singh.

The central bank said high prices of oil and other commodities and the cumulative impact of its policy measures will lead to growth of about 8 percent in the current fiscal year, assuming a normal summer monsoon and global crude oil prices of $110 a barrel.

That puts the RBI's projections a full percentage point lower than the government's own forecasts. Asia's third-largest economy grew by an estimated 8.6 percent in the year that ended in March 2011.

We can now expect rates to be increased by at least another 50 basis points by end-2011. Further rate hikes will depend upon how commodity prices pan out and moderation in growth takes place, said Ashutosh Datar, economist at IIFL in Mumbai.

Under a new arrangement, the repo rate becomes the central bank's only independently varying policy rate, and the reverse repo rate, at which the RBI absorbs excess liquidity, will be pegged 100 basis points below the repo rate, or 6.25 percent after Tuesday's increase.

The move to make the repo rate the only independent variable rate is a move designed to ensure quicker transmission of monetary policy signals, said N.Bhanumurthy, an economist at the Delhi-based National Institute of Public Finance and Policy.

This was needed and perhaps inevitable given the fact that the central bank is embarrassed about the fact that despite eight hikes before today inflation has been at a high of near 9 percent.

The RBI said it expects inflation to remain elevated near March levels in the first half of the fiscal year that began in April before easing in the second half.

It set a target of 6 percent headline inflation, with an upward bias, for the end of the fiscal year in March 2012.

Subbarao said maintaining price stability is required to sustain medium-term growth.

Persistently high rates of inflation raise the risks of inflationary expectations becoming unhinged, Subbarao said.

Analysts polled recently by Reuters had expected 75 basis points of rate increases during the remainder of 2011, including Tuesday's move.

Despite efforts by the central bank to tighten monetary policy, data on Monday showed expansion in the manufacturing sector remained strong in April, helped by higher output and employment, even as similar surveys showed slowing growth for China, where policymakers have taken numerous steps to tame rising prices.

Australia's central bank held interest rates steady at 4.75 percent on Tuesday but warned of underlying inflation that could head higher, reinforcing the case for a further tightening in the coming months.

(Reporting by Suvashree Dey Choudhury and Tony Munroe)

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