* India cbank surprises by holding key rate at 7.75 pct
* RBI warns it is ready to act if inflation does not ease
* Bonds, stocks rally on hopes decision will aid economy (Recasts, adds company executive quote)
By Suvashree Dey Choudhury and Rafael Nam
MUMBAI, Dec 18 (Reuters) - India’s central bank kept talking tough on inflation despite unexpectedly holding its policy interest rate unchanged on Wednesday, saying it will be ready to act even if the country struggles to raise its low growth rate.
The Reserve Bank of India’s decision to keep the repo rate at 7.75 percent surprised investors, who had widely expected the central bank to hike the main lending rate after raising it by a quarter percentage point each at its previous reviews in September and October.
Instead, the RBI noted that prices of vegetables, which are driving the inflation rate higher, are easing, while highlighting “the weak state” of the economy and the uncertainty posed by a possible withdrawal in U.S. monetary stimulus.
However, the central bank described Wednesday’s decision as “a close one” and said it would remain vigilant on inflation, acting between policy reviews should headline or core inflation not ease as expected.
Although many economists predicted the RBI could still raise rates by another 25 basis points hike in the next few months, Wednesday’s decision brought some relief, for now, to business and investors worried about an economy growing even below the decade-low of 5 percent in the previous fiscal year.
“I want to emphasise we are not being soft on inflation,” RBI Governor Raghuram Rajan told reporters at a news briefing after the decision.
“I also want to emphasise that it shouldn’t be taken that we’re on hold. We are waiting for data. Hence as the data come in, we will react appropriately,” he added.
Rajan, a former finance minister adviser, has made fighting inflation a priority since his appointment in September. That is a welcome move for the embattled Congress party, which is facing general elections due by May, and has been hit drubbed in recent state polls, partly due to high food prices.
The RBI’s decision to pause comes as wholesalers say vegetable prices have eased this month, after the most recent data showed consumer prices in November posted their biggest annual rise on record - 11.24 percent - while wholesale inflation hit a 14-month high.
Rajeev Talwar, an executive director at property developer DLF Ltd. NS> called the central bank decision “the first sign of recovery” in an economy growing far below the annual levels of 8 percent the government says are needed to reduce poverty and generate jobs.
“Thank goodness the RBI governor has not panicked. Let us see till February. Hopefully, if food stocks are released in the market, food inflation comes down and that will be the end of the cycle,” Talwar said.
The benchmark 10-year bond yield dropped as much as 15 basis points to 8.76 percent from its previous close, while the NSE share index - up 0.8 percent when the RBI announced the hold - closed up 1.3 percent for the day.
At the heart of India’s surging inflation are the prices of vegetables such as onions and potatoes, which disproportionately hit the country’s poor, traditionally key voters for the Congress party.
However, analysts have expressed doubts about the effectiveness of monetary policy in curbing vegetable prices, whose jump has been driven by India’s poor infrastructure and transportation methods.
Food prices can also be volatile, making the outlook for interest rates hard to discern.
“I think what we are saying is we will not react to every spike in inflation that is temporary. Monetary policy, after all, operates with long lags, three to four quarters,” Rajan said.
The RBI’s decision came only hours before the conclusion of a U.S. Federal Reserve policy meeting. Any decision to start withdrawing its monetary stimulus would raise concerns about a repeat of August, when fears of this sparked outflows that made the rupee plunge to a record low.
Under Rajan, the RBI has rolled back most of the emergency steps taken in July and August to prop up the rupee, which included raising short-term interest rates.
Still, analysts said coming inflation data would drive monetary policy decisions, with Australia’s ANZ calling Wednesday’s interest rate hold a “stay of execution.” (Additional reporting by Swati Bhat and the Mumbai markets team; Editing by Richard Borsuk)