MUMBAI: The Indian rupee posted its biggest single-day gain in over two months, snapping a three-day falling streak after the central bank unexpectedly raised interest rates to bring down consumer inflation.

Investors were also comforted after the Reserve Bank of India (RBI) indicated it did not foresee more near-term policy tightening should retail inflation ease in line with the central bank’s projections.

The rupee has had an uneasy relationship with the prospect of interest rate hikes. Although higher rates can make the currency more attractive for foreign investors, too much tightening can dent economic growth, eroding confidence, and in turn hitting stocks.

The rate hike was intended to curb inflation but also comes as emerging markets have been routed in part by expectations the US Federal Reserve will continue to wind down its monetary stimulus after concluding its two-day meeting on Wednesday.

“We are now looking ahead at the Federal Reserve policy outcome but I don’t think the rupee will weaken more from here. 63 should hold at the top for the pair,” said Uday Bhatt, a foreign exchange dealer with UCO Bank.

The rupee closed at 62.51/52 per dollar compared with 63.10/11 on Monday. The 0.9 percent rise in the rupee is the biggest since Nov. 18.

The RBI’s hike in interest rates also pushed up the marginal cost of borrowing rupees in the overnight market, making it more expensive to fund investments in dollars and thus prompting liquidations of long positions in the greenback.

Traders will continue to monitor foreign fund inflows and outflows from both the debt and equity markets for direction.

Corporate dollar selling by a large engineering firm also helped the rupee, dealers said.

In the offshore non-deliverable forward PNDF, the one-month contract was at 63.14, while the three-month was at 64.00.

The Reserve Bank of India, however, said that if retail inflation eases as projected, it does not foresee further near-term monetary policy tightening.

The rupee sank 11 percent last year as emerging markets sold off sharply after the US central bank announced it would taper its aggressive bond-buying program that had fueled global demand for risk assets.

India’s 25-basis-point rate hike was driven by expectations of high but moderating consumer price index (CPI) inflation, an indication the central bank intends to adopt a recent proposal to base its rate decisions on a CPI target.

RBI Governor Raghuram Rajan faces the daunting challenge of reviving an economy growing at its slowest in a decade while battling stubbornly rising prices, especially for food, fueled by supply-side shortages beyond the control of monetary policy.

HSBC economist Leif Eskesen expects more rate increases from the RBI.

“This was the right decision, but it does not constitute the end to the tightening cycle, in our view. If RBI wants to knock out core inflation, the policy rate will likely have to be hiked further.”

The RBI raised its policy repo rate to 8.00 percent amid market worries over slowing growth in China and the prospect of further tapering of US stimulus.

“We have injected some medicine, 75 bps in rate hikes since September, and we have to watch to see how that medicine works along with, again, the weak state of the economy as well as the stabilization of the rupee,” Rajan told a news briefing.

The Indian economy, which not long ago aspired to double-digit growth, has been weakened by sluggish investment and persistent inflation in recent years under the corruption-scandal battered Congress party government of Manmohan Singh, which faces an uphill battle in elections due by May.

Most economists in a Reuters poll recently had expected no change in rates. However, expectations for a rate hike had increased after a central bank panel proposed to make CPI the main inflation benchmark.

“For now, this should mark the peak of the rate hike cycle, with the central bank’s growth projections close to our conservative estimates,” said Radhika Rao, economist at DBS Bank in Singapore.

The RBI said economic growth was likely to fall short of its earlier projection of 5 percent this fiscal year and improve to 5-6 percent in the year that starts in April.

The CPI eased to a three-month low of 9.87 percent in December, well above the wholesale price index (WPI) , long the RBI’s main price barometer, which slowed to 6.16 percent in December.

Indian bonds, stocks and the rupee fell after the rate increase but recovered most losses due to a statement seen as dovish, although the RBI said that consumer inflation risks remain to the upside.

The benchmark 10-year bond yield rose as much as 13 basis points after the hike before retreating.

Last week, a central bank panel proposed revamping its policymaking structure by setting a long-term CPI inflation target of 4 percent, plus or minus 2 percent. In the intermediate term, the goal would be to trim CPI to 8 percent by January 2015 and 6 percent by January 2016.

“An increase in the policy rate...will set the economy securely on the recommended disinflationary path,” the RBI said.

“If the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture,” it said.

Rajan, who took office in early September, adopted the panel’s recommendation to review monetary policy every two months. It had been reviewing policy eight times a year.

The RBI said CPI inflation was likely to stay above 9 percent during the final quarter of the fiscal year that ends in March, ranging between 7.5 percent and 8.5 percent for the quarter that ends in March 2015, “with the balance of risks tilted on the upside.”