Reserve Bank of India Governor Raghuram Rajan surprised markets in his maiden policy review on Friday by raising interest rates to ward off rising inflation while scaling back some emergency measures put in place to support the rupee.
Rajan raised the RBI's policy repo rate by 25 basis points (bps) to 7.50 percent, defying widespread forecasts that he would leave the rate on hold to bolster a sluggish economy, and as expected struck a hawkish tone.
The RBI rolled back some of the steps that had been imposed to support a currency that had fallen as much as 20 percent to a record low in late August, reducing the marginal standing facility (MSF) rate by 75 bps to 9.50 percent.
The RBI had lifted the MSF rate to 10.25 percent in mid-July to tighten market liquidity and stabilise the rupee, and the MSF had been treated by the market as the effective policy rate.
Indian federal bonds, the rupee and stocks all extended losses after the decision.
"The need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand," Rajan said in his policy statement.
He also said he wanted the repo rate to resume its place as the operational policy rate as the rupee support measures are unwound.
Also on Friday, the RBI partially scaled back the minimum cash balance requirement banks must keep with the central bank on a daily basis.
MOUNTING PRICE PRESSURES
"The governor is clearly worried about inflation," said Anjali Verma, chief economist at PhillipCapital in Mumbai.
"He is saying the improved international conditions will take care of the current account deficit funding and his focus will shift to the fiscal deficit and inflation, which were taking a backseat," she said.
Headline inflation shot to a six-month high of 6.1 percent in August, hardening the case for Rajan to keep interest rates high.
India's record-high current account deficit made it especially vulnerable to the flight of funds from emerging markets that began in May on expectations the Fed would soon begin tapering its extraordinary stimulus.
Since Rajan took office, the rupee had recovered more than 9 percent through Thursday, getting a further boost this week after the U.S. Federal Reserve unexpectedly opted not to begin scaling back its stimulus programme.
Rajan said on Friday that domestic drivers of the rupee now take precedence.
"The focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation," he said.