The RBI said that reversing its accommodative monetary policy would be ineffective unless the government cuts borrowing, on track to hit a record 4.5 trillion rupees ($97 billion) this fiscal year, putting pressure on the government to rein in spending when it releases its budget on February 26.
"I think they're lining us up for something more in the not-too-distant future," said Robert Prior-Wandesforde, senior Asia economist at HSBC in Singapore, who expects a rate increase before the April meeting. Stocks, bonds and the rupee all weakened in their initial reaction to the central bank's decision to raise the reserve ratio by 75 basis points before paring losses.
Investors had priced in a 50 basis point reserve rise as well as an increase in lending rates by April. Analysts' expectations for a rate increase in the next three months were little changed in a new Reuters poll after the policy review. India is joining a trend in other major emerging economies towards gradual tightening of loose monetary policies.
This month, China started to tighten policy by raising banks' reserve requirements, clamping down on loan growth and accepting higher yields at bill auctions. On Wednesday, Brazil - another member of the BRIC quartet of emerging powers that also includes Russia - held rates steady but left the door open for a possible rate hike. Despite rising inflationary pressures, the Indian government has pressured the RBI to hold off raising rates, saying it could undermine economic recovery.
Raising rates could also curb bank lending that has just started to recover, and spark potentially destabilising capital inflows. One-year swap rates rose 11 basis points on Friday in anticipation of higher interest rates, but the reaction was limited in other markets on a view the central bank is unlikely to act before the government budget release in February.