Central Banks

India targets inflation, but high prices may persist

Leslie Shaffer | Writer for CNBC.com

India's central bank may have picked the rock over the hard place on Tuesday, hiking interest rates to control inflation despite slowing economic growth, but economists don't expect prices to react any time soon.

"India has had a structural inflation problem for some time now. Some of the pricing mechanisms in this economy have broken down. Policy needs to be kept relatively firm for an extended period to bring down inflation expectations," Glenn Maguire, chief economist for Asia-Pacific at ANZ, said in a phone interview with CNBC.

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The RBI raised the benchmark repo rate by 25 basis points to 7.75 percent Tuesday, in line with expectations, after hiking the rate by 25 basis points in September.

India's economic growth has slowed sharply from around 8 percent annually between 2002 and 2012 to about 5 percent for 2012-13, compared to the U.S. economy which grew at a 2.5 percent annual rate from April through June, while China's gross domestic product climbed 7.8 percent in the third quarter.

Meanwhile, India's wholesale price index for September rose to a seven-month high of 6.46 percent, while the consumer price index grew at 9.84 percent, its fastest pace in three months, driven in part by higher food prices, including a 322 percent jump in onion prices.

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"It is important to break the spiral of rising price pressures in order to curb the erosion of financial saving and strengthen the foundations of growth," Raghuram Rajan, who took the helm as Reserve Bank of India (RBI) governor in early September, said in a RBI statement Tuesday.

"Curbing mounting inflationary pressures and managing inflation expectations will help strengthen the environment for growth by fostering macroeconomic and financial stability."

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But economists expect India's growth and inflation outlook will only transition slowly.

While the central bank expects economic growth to pick up in the second half of the current fiscal year, "the RBI is overestimating the size and underestimating the time it takes for interest rate moves to impact price increases," said Robert Prior-Wandesforde, an economist at Credit Suisse, in a note.

He expects it will take 12-18 months for monetary tightening to affect real economic activity. Credit Suisse forecasts India's gross domestic product to grow 5.4 percent for the current fiscal year, before climbing to 6.5 percent in the 2014-15 fiscal year.

Analysts say Rajan has a tough task on his hands. On the one hand, the central bank wants to reassure markets that it will do all it can to keep inflation under control, but there is also some concern that raising rates too high could put further pressure on a slowing economy.

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Kuni Takahashi | Bloomberg | Getty Images

"The extent and duration of the growth slowdown would have suggested that India would not be out of place in the ultra-easy policy or quantitative easing club," Maguire said in a note. "India's markedly higher inflation, even as growth has retrenched, compared to emerging market peers, rules out easier policy."

Maguire believes Rajan is trying to slow growth to allow excess capacity to build up, which should help to slow inflation and allow non-inflationary growth in the medium term.

In addition to a laser-like focus on inflation, the RBI's new chief also is moving the central bank to a "simpler and more transparent framework," ANZ's Maguire noted.

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The RBI continued to unwind some of the crisis measures it put in place to limit outflows and counter the May-to-September market volatility which sent the rupee sharply lower amid concerns over India's current account deficit.

The U.S. dollar strengthened from buying around 53.80 rupees in early May to a record peak of around 68.80 in late August; it is currently around 61.43.

The RBI lowered its Marginal Standing Facility, or MSF, rate by 25 basis points to 8.75 percent on Tuesday.

"Normalcy can be thought of as having returned, reflecting the greater stability of the rupee," Prior-Wandesforde said.

By CNBC's Leslie Shaffer. Follow her on Twitter: @LeslieShaffer1