The Reserve Bank of India also raised its inflation forecast for the year from 7 percent to 8 percent on high crude prices and rising manufacturing costs, saying that its current anti-inflationary stance is likely to continue despite instability in the Middle East and natural disasters in Japan.
"The underlying inflationary pressures have accentuated, even as risks to growth are emerging," the bank said.
As expected, the central bank raised the repo rate — its short term lending rate — from 6.5 percent to 6.75 percent with immediate effect. It raised the reverse repo rate — its short term borrowing rate — by 5.5 percent to 5.75 percent.
The move disappointed business leaders, who say the rising cost of finance and materials is already weakening confidence and crimping growth.
"RBI's action in raising policy rates though expected will adversely affect growth prospects", said Rajiv Kumar, the director general of the Federation of Indian Chambers of Commerce and Industry, a major business lobby.
Central banks across Asia have raised rates in their fight against inflation, but India has been more aggressive than most. While India's Reserve Bank continues to prioritize its anti-inflation battle, it is clearly grappling with new fears that sweeping political change in the Middle East and last week's catastrophic earthquake and tsunami in Japan will hamper global growth.
Despite a largely domestic driven economy, India's reliance on oil imports and the impact of short term foreign fund flows on capital markets and currency make it vulnerable to global events.
India imports about three-quarters of its oil and the government pays hefty subsidies on fuel and fertilizer.
That means rising crude prices threaten not just inflation, but also the sizable current account and fiscal deficits.
The Reserve Bank said it's too early to assess the impact of the natural disaster in Japan on India's economy, but warned that a turn from nuclear energy could exert further upward pressure on petroleum prices.
The bank urged policymakers to contain spending on subsidies, increase agricultural productivity to ease supply constraints that have caused prolonged double digit food inflation and work to attract long-term capital inflows from foreign direct investment.
It added that India is on track to clock 8.6 percent growth this year — data on industrial production, car sales, merchandise exports, tax collections and bank credit have all been robust — but cautioned that uncertain commodity prices could dampen the investment climate.
"Investment momentum may be slowing down," the bank said.
Rising prices, along with a crush of corruption scandals, have battered India's ruling Congress Party coalition, spurring street protests in some places.
India's latest inflation data — 8.3 percent for the month of February — took many by surprise.
"It's no longer a food inflation problem," said HDFC Bank Chief Economist Abheek Barua. "The economy seems to be showing signs of overheating." He said the bank may hike rates 4 to 5 more times over the next year, but cautions that things could quickly change if the Middle East and Japan don't stabilize.
"If we see continued traction in oil prices and they remain high long enough to impact adversely on growth then the nature of the game changes," Barua said. "Perhaps the RBI and other central banks will have to think of going easy to prevent a collapse in growth and financial markets.
Things could change dramatically." Thursday's news also disappointed investors, who sent the benchmark Sensex down 1.1 percent, to close at 18,149.9 on the Bombay Stock Exchange.
