UPDATE 2-India cbank raises rates by 50 bps, exceeding forecasts

Tue May 3, 2011 2:09am EDT

* Fighting inflation takes precedence over short-term growth- cbank

* Inflation to remain near March levels in first half of FY12- cbank

* Risk of inflationary expectations becoming "unhinged"

* Bond yields, swap rates rise sharply after rate rise (Edits)

By Tony Munroe and Suvashree Dey Choudhury

MUMBAI, May 3 (Reuters) - India's central bank raised interest rates by a sharper-than-expected 50 basis points on Tuesday and said fighting inflation is its priority, even at the expense of short-term growth.

The rate rise was its ninth since March 2010, and exceeded market and economists' expectations for a 25 basis point rise, although the case for stronger action had been building since March headline inflation reached nearly 9 percent.

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

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

Asia's third-largest economy grew by an estimated 8.6 percent in the year that ended in March 2011.

"Current elevated rates of inflation pose significant risks to future growth," Reserve Bank of India 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 following the larger-than-expected rate rise, while the 10-year benchmark bond yield rose 4 basis points to 8.21 percent.

"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 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, and 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 for the remainder of 2011, including Tuesday's move.

Despite the central bank's ongoing tightening of monetary policy, data on Monday showed that India's manufacturing sector maintained a strong rate of expansion in April, helped by higher output and employment, even as a similar surveys showed slowing growth for China, where policymakers have taken numerous steps to tame rising prices. [ID:nL3E7G20L7] (Reporting by Suvashree Dey Choudhury and Tony Munroe)

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