India raises interest rates rise to stem inflation

India's manufacturing sector has suffered because of higher interest rates as Puneet Pal Singh reports.

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India's central bank has unexpectedly raised interest rates in an attempt to rein in stubbornly high consumer prices in a crucial election year.

The Reserve Bank of India (RBI) raised the benchmark repo rate - the amount at which it charges to lend to commercial banks - to 8% from 7.75%.

Economists had expected no change after its meeting in Mumbai on Tuesday.

The RBI said that another near-term hike was unlikely if inflation eased to a more comfortable level.

India's main gauge of inflation, the wholesale price index (WPI), rose 6.16% in December, from a year earlier. While that was a slight fall on from the previous month, the rate continues to remain an issue with the central bank.

'Weakens growth'

Meanwhile, the country's consumer prices index (CPI) - which is seen as the key gauge of inflation across most other countries - rose at an annual rate of 9.87% in December.

"Inflation excluding food and fuel has also been high, especially in respect of services, indicative of wage pressures and other second-round effects," the central bank said in a statement.

"Elevated levels of inflation erode household budgets and constrict the purchasing power of consumers. This, in turn, discourages investment and weakens growth."

Analysis

The Indian central bank governor - Raghuram Rajan has done it again. Just when everyone was expecting the central bank (the RBI) to hold interest rates, they have hiked them again, taking the markets by surprise.

But the decision clearly underlines the RBI's top priority - fighting the stubbornly high inflation which has been a big bottleneck for the economy over the last two years.

High food and fuel prices have affected most people and were one of the main reasons for the huge electoral defeat of the ruling Indian coalition government in the recent state elections. And inflation remains a key political issue even in the upcoming general elections - which are due in April - May this year.

Even though food prices have cooled down in the past month, the central bank does not want to take any chances. And by increasing interest rates at this juncture, it wants to steer the economy on the path of low inflation even if it comes at the cost of slow economic growth in the short term.

The RBI last week had proposed setting a target of 4% consumer inflation by 2016.

It said that the increase in the policy rate "will set the economy securely on the recommended disinflationary path".

RBI chief Raghuram Rajan had left rates unchanged at the bank's last policy meeting in December, after raising the benchmark rate in September and October.

India's main share index fell following the announcement, with lenders such as ICICI Bank leading the decline.

Price problem

India has been struggling to control what is Asia's highest inflation level, which was running at about 10% last year.

Rising prices have impeded economic growth in the country, which has also been under pressure from a weakened currency.

The Indian rupee has lost about 14% of its value over the past 12 months, which has made the cost of imported products more expensive.

Higher inflation causes consumers to spend less, and its impact is felt most by India's poor. According to the World Bank, nearly two-thirds of India's population live on less than $2 a day.

The central bank said in its statement that "inflation is also a tax that is grossly inequitable, falling hardest on the very poor".

Companies higher input costs have prompted some to raise prices.

Authorities have been trying to bring down prices, as inflation is also a politically sensitive issue in India.

The country is due to hold general elections in May.

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