By Tony Munroe and Suvashree Dey Choudhury
MUMBAI (Reuters) - Reserve Bank of India (RBI) Governor Raghuram Rajan surprised markets in his maiden policy review on Friday by raising interest rates to ward off rising inflation, while scaling back some of the emergency measures recently put in place to support the ailing rupee.
Rajan, who took office early this month amid worst economic crisis since 1991, increased the RBI's policy repo rate by 25 basis points (bps) to 7.50 percent, defying most forecasts that he would leave the rate on hold to bolster a sluggish economy.
As expected, the former IMF chief economist struck a hawkish tone on price pressures in Asia's third-largest economy.
He was non-committal about the direction of the next policy rate move but said he intends to continue withdrawing liquidity tightening steps that had been implemented to stabilise the currency as market conditions allow.
While raising the traditional policy rate, Rajan freed up market liquidity with a three-quarter point cut in an overnight borrowing rate that the central bank had temporarily raised by 200 bps in July to support the rupee.
"In our view, the RBI has risked sending a confused signal to markets, and the withdrawal of tightening measures may be premature," Goldman Sachs economist Tushar Poddar wrote, adding that he expects the rupee to remain under pressure.
However, several traders said they expected the rupee to soon to resume its recent recovery from a record low on August 28, propelled by the U.S. Federal Reserve's decision not begin tapering its stimulus, as well as the Indian rate hike.
On Friday, the rupee fell, while stocks and bonds also weakened.
Despite an economy that grew at just 4.4 percent in the June quarter, its weakest in four years, Rajan opted to increase policy interest rate for the first time in nearly two years, following similar moves by Indonesia and Brazil, whose currencies have also been hit by heavy capital outflows in recent months.
The wholesale price index (WPI) inflation rose to a six-month high of 6.1 percent in August, with consumer price inflation (CPI) at 9.52 percent.
"In the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year," Rajan, 50, said in a policy statement that reaffirmed his penchant for surprise.
In his first day on the job, Rajan unexpectedly outlined an action plan to revive the rupee and bolster financial markets and the banking system.
"What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence," he said.
While Indian growth rates are less responsive to interest rate changes than in some countries, Indian voters are highly sensitive to inflation. Several states hold elections in coming months, with the general election due by May.
"What's clear now is that Rajan is very focused on containing inflation and the currency, and that means high interest rates until we see prices coming down and a greater fiscal discipline," said Aneesh Srivastava, Chief Investment Officer, of IDBI Federal Life Insurance.
For full coverage on the RBI review, click http://in.reuters.com/subjects/rbi-policy-review
ROLLING BACK RUPEE SUPPORT
The rupee fell as much as 20 percent this year to a record low in late August as investors pulled money from emerging markets ahead of an expected move by the Fed to begin scaling back its massive stimulus.
It has recovered some of those losses since Rajan took over at the RBI amid high expectations on September 4, gaining about 9 percent through Thursday.
"The statement clearly has a strong hawkish bias as it states that with a relatively more stable exchange rate, monetary policy formulation will be determined once again by internal determinants viz inflation and fiscal deficit," said Anubhuti Sahay, economist at Standard Chartered in Mumbai.
The Fed's surprise move to forge ahead with its easy money policy gave Rajan extra space to roll back some of the steps imposed to bolster a currency that had been the worst performer in Asia, dragged down by investor worries over the country's record current account deficit.
Rajan, who famously forecast the global financial crisis, said on Friday that domestic drivers of the rupee now take precedence: "The focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation.
The RBI on Friday reduced the marginal standing facility (MSF) rate to 9.50 percent, which makes borrowing cheaper for banks. Since mid-July, the MSF has been widely been viewed as India's effective policy rate.
Rajan said on Friday he wants the repo rate to resume its place as the operational policy rate as temporary rupee support measures are unwound, returning the gap between the repo rate and the MSF rate to its customary 100 basis points.
"It could be that we walk (move) more on the MSF side, but it could be that the repo rate will do some of the walking. I want to be at this point entirely neutral on what the next step would be. It would be dependent on economic conditions," he told a media briefing.
(Additional reporting by Neha Dasgupta, swati Bhat, Subhadip Sircar, Archana Narayanan, Aradhana Aravindan and Himank Sharma; Editing by Kim Coghill)