India's industrial output fell in October for the first time in more than two years as capital goods investment slumped, ramping up pressure on the central bank to ease monetary or liquidity conditions, possibly as soon as Friday.

Production at factories, mines and utilities plunged 5.1 percent from a year earlier, far worse than expected, another blow for the embattled government of Prime Minister Manmohan Singh that is struggling to combat a slide in the economy.

It is a lot worse than we expected. The nearly two years of monetary tightening is clearly being felt, said Tim Condon, head of Asian economic research at ING in Singapore.

While India may not be a manufacturing-driven economy, more data prints such as this would be a worrying sign. While we expect a status quo in terms of interest rates from the RBI (Reserve Bank of India) this week, the pressure is clearly building on them to start easing, he said.

The fall in industrial output was 10 times greater than economists had forecast in a Reuters poll and marked the steepest drop since March 2009. An upward revision in September's increase to 1.99 percent offered little consolation.

India's economy is contending with 13 rate rises since early 2010, a policy tightening that has hit growth but done little to counter near double-digit inflation.

On Friday, India's finance ministry slashed its growth forecast for the fiscal year ending in March to between 7.25 and 7.75 percent from 9 percent estimated in February.

Just last week, Singh made an embarrassing retreat from opening up the retail sector to allow foreign players like Wal-Mart Stores Inc into the supermarket industry.

Indian stocks <.BSESN> extended losses to 1.67 percent after the data and the rupee weakened to 52.46/47 per dollar from 52.37/38 before the data.

The 10-year benchmark bond yield eased 6 basis points to 8.46 percent, while the five-year swap rate and the one-year swap rate fell 3 and 2 basis points, respectively.

LIMITED OPTIONS

The government has little fiscal room for maneuver to help Asia's third-largest economy as its deficit outlook worsens.

Instead, the data could sway a hawkish central bank to accelerate its swing to easing its policy stance, following in the steps of China, Brazil and others as the global economy feels the chill of the euro zone debt crisis.

The RBI has raised its key lending rate by a total of 375 basis points since March 2010 to combat inflation that has stayed above 9 percent for nearly a year.

But with data on Wednesday expected to show inflation remains above 9 percent, the RBI is not expected to begin cutting interest rates at its mid-quarter review on Friday.

Instead, some watchers expect it to lower the cash reserve ratio, the share of deposits banks must keep with the central bank, in order to ease tight market liquidity, or pledge more support for short-term funding markets.

Still, Wednesday's wholesale prices data is expected to show that inflation is heading down. A Reuters poll suggests it fell in November to 9.04 percent from 9.73 percent in October, as food prices fell to their lowest in nearly three-and-a-half years.

We think WPI, and the market now thinks, that WPI inflation is going to show its first meaningful decline in about 18 months, and that therefore this is going to be a very dovish week for India, said Robert Prior-Wandesforde, an economist at Credit Suisse in Singapore.

Does that mean we are going to get a cut at the next meeting? I very much doubt it. I think they will want to see, A: if this is just a temporary blip and, B: they would want to see if they get further slowing in WPI inflation, he said.

India's government has limited room to support the economy as its fiscal deficit is forecast to reach 5.5 percent of GDP in the financial year to March 2012, 1 percentage point above the target.

New Delhi has already unveiled 528 billion rupees of extra borrowing for the remainder of this year.

DEEPENING GLOOM

Policymaking gridlock as Singh's government is distracted by a series of corruption scandals has stalled reforms, curbed development of infrastructure sorely needed to ease inflation and eroded investor sentiment.

In the July-September quarter, annual economic growth was 6.9 percent, the slowest in more than two years.

A nearly 15 percent drop in the rupee this year adds to the sense of crisis and complicates the central bank's inflation-fighting by making imports more expensive.

Capital goods production, or output of things like machinery and so a barometer of investment in the economy, plunged 25.5 percent from a year earlier, Monday's data showed.

Manufacturing output, which contributes about 76 percent to industrial production, fell an annual 6 percent in October, reflecting weak demand at home and overseas.

Mining output fell 7.2 percent, hurt by policy and regulatory uncertainties. Consumer non-durables output shrank an annual 1.3 percent.

With investment stalling, many private economists expect the economy to struggle to grow even at 7 percent this year.

Other emerging economies, weighed down by Europe's festering debt crisis and a sluggish U.S. economy, have begun to take steps to shield themselves. China and Brazil are among several countries that have relaxed monetary policy.

The RBI is expected to reverse its tight monetary stance next year if inflation eases below 7 percent, and Monday's data might compel it to bring forward its course reversal.

(US$1 = 52.405 rupees)

(Additional reporting by Frank Jack Daniel in New Delhi; Sumeet Chatterjee and Ketan Bondre in Mumbai; and Saikat Chatterjee in Hong Kong; Writing by Tony Munroe; Editing by Neil Fullick)

India China Quantitative easing Inflation