The Reserve Bank of India (RBI) on Tuesday raised key interest rates by 25 basis points, as expected, to battle near double-digit inflation, signalling gradual tightening ahead to sustain growth and manage record government borrowing.
The RBI also raised its cash reserve ratio (CRR) requirement for banks by 25 basis points, as expected to drain further liquidity from the financial system.
The benchmark 10-year bond yield fell to 7.98 percent immediately after the news as some players had bet on a bigger, 50 basis point rise, but bounced back later to 8.04 percent at 0630 GMT.
The main 30-share BSE index extended gains to over 0.8 percent from 0.4 percent before the policy announcement.
The rise follows a quarter-point hike in mid-March when India became the second Group of 20 economy after Australia to lift interest rates as the global economy recovers from its worst downturn in generations.
"With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalising our policy instruments," RBI Governor Duvvuri Subbarao said in the policy statement.
Some economists said that while the central bank's 8 percent growth forecast for the current financial year was realistic, it might have been too optimistic in its prediction that inflation will come off current highs over the course of the year.
"The policy statement is not hawkish enough to address the concerns on the inflation front," said Rupa Rege Nitsure, chief economist at the Bank of Baroda in Mumbai.
"I feel RBI at this juncture is more constrained by the management of the government's record borrowing programme."
A gradual approach to tightening could also benefit the government politically, which has traditionally been more concerned keeping up fast growth rather than clamping down on inflation despite rising protests over high food prices.
Price pressures are spreading beyond food to costs of fuel and manufactured goods such as cars. March inflation reached 9.9 percent year-on-year, its fastest pace in 17 months.
Only China is growing faster among major economies, and analysts expect the central bank to continue increasing interest rates throughout the year to bring them back towards pre-crisis levels.
The RBI lifted the reverse repo rate, at which it absorbs excess cash from the banking system to 3.75 percent and raised the repo rate, at which it lends to banks, to 5.25 percent.
The rise in the cash reserve requirement to 6.0 percent, effective from April 24, which will drain 125 billion rupees ($2.8 billion) from the system.
While government officials say inflation will subside in coming months, some economists expect it to remain high for longer.
The RBI said inflation developments are "worrisome", but forecast headline wholesale price inflation will moderate to 5.5 percent by the end of the current fiscal year in March 2011.
A successful summer monsoon would help ease the pressure from high food prices following last year's drought, although it might also add to demand-driven inflation. A move towards market-determined fuel prices, which the government has put on hold amid opposition attacks over rising prices, would also add to headline inflation.
Subbarao said inflation is becoming increasingly generalised, with evidence that pricing power for companies has returned.
"With the growth expected to accelerate further in the next year, capacity constraints will re-emerge, which are expected to exert further pressure on prices," he said.
"Inflation expectations also remain at an elevated level. There is, therefore, a need to ensure that demand side inflation does not become entrenched," he said.
The RBI is under pressure not to raise rates aggressively from the government that is worried it could dent economic growth and also complicate its borrowing, which will reach a record $100 billion in the current fiscal year.
Bond yields shot higher this month on worries over inflation and government borrowing, with the yield on the 10-year benchmark bond rising to an 18- month high of 8.13 percent last Thursday.