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Are onions the new headache for India’s central bank?

Noah Seelam | AFP | Getty Images

Efforts to support the beleaguered rupee may end in onion-inspired tears.

Already struggling with its currency's sharp drop against the dollar, slowing economic growth and investors' pullback from emerging markets, India also saw inflation rate climb to 5.79 percent in July, its fastest pace in five months and above the 5 percent economists had expected.

Food inflation rate rose to an annualized 9.5 percent in the month, led by a spike in onion prices which Citi said were up 34 percent from June. Onion prices have been rising in India as the crop has been hit by excessive rains.

(Read more: India's ministers watch their onions)

The volatile price of onions has been credited with toppling two Indian governments since 1980, as many Indians use onions in almost every meal, and some form of bread with onion is regarded as a basic diet for the poor.

But the biggest risk from the accelerating inflation is that it intensifies India's policy dilemma, said Vishnu Varathan, market economist at Mizuho Corporate Bank.

"We can infer from the policy moves that policy makers are prioritizing rupee stability. It's very high on the agenda," said Varathan.

"(But) markets are wondering whether the inclination to support growth might creep in sooner or later," he added.

(Read more: Four reasons not to 'throw in the towel' for India)

India's rupee has fallen nearly 13 percent against the dollar year-to-date, brushing a fresh record low around 61.87 last week. The Reserve Bank of India has taken dramatic measures starting from July 15 to raise short-term interest rates and drain market liquidity, while the government has sought to curb gold, silver and "non-essential" imports as well as demand for oil in an attempt to shore up the rupee.

On Wednesday, the RBI upped the ante, imposing measures to limit companies' foreign investments as well as residents' outward remittances and ability to buy "immovable" property outside India. Economists have likened the moves to capital controls and said policy makers may be sending panic signals.

(Read more: Is India's rupee back in the danger zone?)

At the same time, policy makers are facing a growth slowdown. For the full fiscal year that ended in March, growth came to 5 percent – its slowest pace in a decade.

The combination of higher-than-expected inflation and slow growth has led some economists to question whether stagflation might emerge.

"Certainly, if inflation continues to be upwardly biased for CPI and WPI and those pressures aren't alleviated, then certainly it seems to be moving toward a stagflation scenario," Varathan said, although he noted that rather than the traditional "external shock" driving the scenario, India's inflation is the result of "long unaddressed" structural impediments.

(Read more: Can the new RBI chief survive India's 'poisoned chalice?')

But not everyone is expecting this scenario.

"The combination of high inflation and low growth won't reverse any time soon," said Rajeev Malik, senior economist at CLSA. But, "it's not going to have runaway inflation as such," he added.

Malik expects the latest inflation data to dash hopes for a reversal of tightening measures.

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