India's economy grew at its fastest pace in nearly three years in the April-June quarter on strong manufacturing growth and better farm output that may keep the central bank on its gradual monetary tightening path.

Tuesday's data showed annual rate of growth picked up to 8.8 percent from 8.6 percent in the previous quarter, underscoring continued growth momentum in Asia's third-largest economy amid a slowing pace of global recovery.

The robust growth bolsters the case for further interest rate increases and some bond dealers anticipate a 25-basis point rate rise already at a September 16 central bank policy review. The central bank, however, appears reluctant to hurt growth by raising rates aggressively, so it is expected to continue using a combination of small rate rises in conjunction with keeping banking system liquidity tight.

The benchmark 10-year bond yield fell by two basis points to 7.95 percent after the release of data.

Policymakers will be more interested in the potential impact of slower global growth in the months ahead rather than the fact that domestic growth was strong earlier this year, said Brian Jackson, senior emerging markets strategist at Royal Bank of Canada in Hong Kong.

However, with inflation still in double-digit territory in recent months, the RBI remains firmly focused on getting price pressures under control. We continue to expect further policy tightening in coming months, forecasting benchmark rates to be hiked another 50 basis points by the end of the year.

INFLATION FOCUS

The Reserve Bank of India has raised interest rates four times since mid-March and has said it may have to give precedence to containing inflation over other policy objectives.

Strong economic growth has raised the specter of capacity constraints, which analysts hold partly responsible for the stubbornly-high headline inflation, which stood at 9.97 percent last month.

Although India's wholesale price index in July rose at its slowest pace in six months, underlying price pressures remain.

The ruling Congress party has said that controlling prices must be the top goal in the face of popular discontent with rising costs affecting hundreds of millions of people who live on under $1.25 a day.

RBI Governor Duvvuri Subbarao last week said inflationary pressures were easing, but analysts say this is unlikely to deter him from raising rates again to slow down headline inflation to 6 percent by March 2011.

GROWTH OPTIMISM

Policymakers are confident India will meet growth targets in the current financial year.

On the whole, the projections that we have been making of 8.5 percent stays; it could be a little better, said Montek Singh Ahluwalia, deputy chairman of India's Planning Commission, after the release of data.

Government spending is also expected to pick up after the June-September monsoon rains, said Ahluwalia.

There are, however, signs India's break-neck growth may be moderating, with recent data showing a slowdown in factory output growth. Industrial output in June expanded at its slowest rate in 13 months.

The pattern mirrors that in Asian peer China, the only major economy which is growing faster than India, where worries of softening growth were accentuated by data that showed easing in investment and factory output.

But India's domestic-demand driven economy is benefiting from buoyant consumer demand that is pushing up car sales and making factories produce to their optimum capacity. Annual car sales in India rose 38 percent in July.

We expect GDP growth in China to settle out at around 8 percent next year, so India should finally outperform its big rival over the next 1-2 years, Kevin Grice, senior international economist with London-based Capital Economics wrote in a note.

India's June-quarter manufacturing output jumped 12.4 percent on year compared with a revised annual rise of 3.8 percent in the previous year.

Its farm sector expanded 2.8 percent and is expected to see robust growth on good monsoon rains, which is likely to further boost consumer demand by lifting rural income.

(Editing by Malini Menon and Tomasz Janowski)

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