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UPDATE 3- Indian inflation spike hits bonds, spurs rate policy and fiscal worries

worries@

* Inflation surprise puts bond yields at highest since July 2016

* Jump in inflation threatens economy, challenge to policymakers

* Rate hike not easy call as worries about economy persist

* Focus also on government's finances, electoral prospects (Recasts, adds quotes and details)

MUMBAI, Dec 13 (Reuters) - India's benchmark 10-year bond fell to its lowest in more than 16 months on Wednesday, as investors saw surging inflation as a potential threat to a still-struggling economy and a daunting challenge to policymakers.

The 10-year bond yield rose as much as 6 basis points to 7.26 percent, the highest since July 2016, after data late on Tuesday showed annual inflation spiking to a 15-month high of 4.88 percent in November, way above expectations.

That rate was sharply above the Reserve Bank of India's 4 percent medium-term inflation target, and was driven higher by a sharp rise in food prices.

The elevated inflation rate creates a dilemma for the Reserve Bank of India, raising the prospect it could respond with a rate hike even as the economy is growing at far below the 8 percent pace needed to create jobs for millions of youths joining the workforce annually.

Furthermore, the 75 basis point rise in bond yields since June end could lead to higher borrowing costs and steep mark-to-market losses at the country's lenders, India's biggest bond investors. That, in turn, would hurt their ability to extend the loans needed for an economic revival.

For now, analysts said they still expect the RBI to hold its repo rate at a more than 7-year low of 6.00 percent after last cutting it in August, but warned that the odds of a hike had risen.

The RBI's monetary policy committee (MPC) next meets in early February.

"We now see 30 percent chance of a precautionary rate hike in the February policy (meeting) itself, with the MPC facing an acute trade-off between sluggish growth and rising inflation for the first time in its short existence," Citigroup wrote to clients on Wednesday.

NOT AN EASY CALL

The surge in food prices is unlikely to cool, according to farmers who say unseasonal rains in October and in early December reduced production of vegetables such as onions and tomatoes.

Also, the government has set higher support prices for wheat and pulses to help a rural sector hit hard in recent years by low food prices.

Raising interest rates won't be an easy call for the RBI, which took advantage of an extraordinary period of low inflation to cut them by 200 basis points from January 2015 until August, the longest easing cycle since the 2008 global financial crisis.

Government officials are bound to disagree with any rate hikes, given their concerns about the economy.

Data on Tuesday also showed that annual industrial output grew a lower-than-expected 2.2 percent in October, falling short of a forecast 3.0 percent. That indicated an economy still on the mend even as growth recovered to 6.3 percent in July-September, halting a five-quarter slide.

FOCUS ALSO ON GOVT

For bond investors, the inflation data is the latest bad news in a year in which prices are on track to fall after three years of gains.

The surge in bond yields also threatens to dent credit growth at a time Prime Minister Narendra Modi's government badly needs banks to lend more, leading policymakers to unveil a $33 billion recapitalisation plan for the sector.

"If the borrowing cost overall goes up in the economy then the effectiveness of the government's recapitalisation plan intended at boosting credit might get hit," said Soumya Kanti Ghosh, chief economist at State Bank of India.

Bond investors already have been worried that the government will have to widen its 3.2 percent fiscal deficit target for the year ending in March, leading to increased borrowing.

Investors also worry the government might try to prepare for the 2019 election by announcing a slew of populist measures next year.

These expectations could rise if the ruling Bharatiya Janata Party emerges from ongoing elections in Gujarat with a sharply reduced majority, indicating discontent in the state that Modi once led.

After Modi "enjoyed a comfortable fiscal position thanks to lower global crude oil prices" he is now "entering into an unknown territory on the macro front ahead of general elections," said N.R. Bhanumurthy, an economist at National Institute of Public Finance and Policy, a Delhi-based think-tank. ($1 = 64.4300 Indian rupees) (Reporting by Suvashree Dey Choudhury, Rajendra Jadhav and Manoj Kumar; Additional reporting by Swati Bhat; Writing by Rafael Nam; Editing by Eric Meijer and Richard Borsuk)