Mumbai: The Reserve Bank of India (RBI) on Friday increased its key policy rate by 25 basis points (bps), the 12th such hike since March 2010, reinforcing its stance that persistently high inflation continues to be its biggest worry, despite signs that economic activity is slowing down in the world’s second fastest growing major economy.

A basis point is one-hundredth of a percentage point.

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With the 25 bps hike, in sync with market expectations, the policy rate has risen to 8.25%.

Commercial banks will have to pay more if they want to borrow from RBI, but individual borrowers as well as corporations may not feel the impact of the rate hike immediately as banks are not in a hurry to raise their loan and deposit rates.

Sandeep Bhatnagar/Mint

BSE’s benchmark equity index, the Sensex, gained 0.34% to end at 16,933.83 points.

Union finance minister Pranab Mukherjee said the move was necessary to reign in inflation.

“I am hopeful that measures taken (by RBI) would get us back to a more comfortable inflation situation earlier rather than later...while (leaving) scope for growth to pick up in the second half of the year," he told reporters in New Delhi.

Most economists expect another rate hike before RBI presses the pause button, but industry lobby groups are distinctly unhappy.

Rajiv Kumar, secretary general of industry body Federation of Indian Chambers of Commerce and Industry (Ficci), cast a doubt on RBI’s ability to control inflation with the current spate of interest rate increases.

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“Even as RBI justifies this rate hike for dampening inflationary expectations, it is difficult to fathom that this will be achieved, when a cumulative rate hike of 325 bps since March 2010 could not achieve this objective," said Kumar, adding that the rate hike will only “exacerbate the current fears of an impending slowdown".

Indranil Sengupta, chief economist for India at Bank of America-Merrill Lynch, said there could be one more rate hike in October. “We now believe that the RBI will drag its rate hiking cycle to 25 October —unless the US double dips —after today’s policy," he said, referring to the prospect of a so-called double-dip recession in the world’s biggest economy.

According to Leif Lybecker Eskesen, chief economist for India and Asean (the Association of Southeast Asian Nations) at HSBC Global Research, HSBC Bank, further hikes are “certainly on the table" and the bank expects at least another 25 bps hike. “This could come as soon as Q4 this calendar year and possibly at the next meeting", unless there is a further worsening in the global economic environment or a better-than-expected outcome on the inflation front, he said.

Standard Chartered Bank, too, said RBI will go for another rate increase.

RBI kept its options open and stayed away from making any commitment on the future course of action, while saying it will continue with its anti-inflationary stance. It expects inflation to remain high in the coming months and said its stance will be influenced by three factors—downward movement in the inflation trajectory, a moderation in demand and global developments.

If the situation in Europe and the US worsens dramatically, RBI will be forced to pause and even reverse its stance earlier than expected, some analysts said.

Developments in the global economy over the past few weeks “are a matter of serious concern" and India’s exports will be affected “in the face of weakening global demand", the RBI release said.

Inflation in August rose to 9.78%, the highest in 13 months. An increase in fuel prices since Thursday midnight and a fall in the value of the rupee could add to inflation pressures in the coming months. The local currency touched 48 to the dollar on Wednesday, significantly weaker than at the start of the month. A weak rupee makes import bills costlier and pushes up prices.

Justifying the hike, RBI said it would be “premature" to reverse its hawkish stance in the current scenario as “it could harden inflationary expectations, thereby diluting the impact of past policy actions".

According to the central bank, in all likelihood, inflation will remain high for the next few months, and in this environment, “rising inflationary expectations remain a key risk". Inflation remained “high, generalized and much above the comfort zone of the Reserve Bank", it said, adding, there were “continuing demand pressures" with an “element of suppressed inflation".

RBI did acknowledge that a tight money policy is contributing to the slowdown in domestic demand and that risks to the growth projection for 2011-12 made in the July policy review are “on the down side". Companies are also facing margin pressure, but “barring a few sectors, significant pass-through of rising input costs is still visible". This meant that RBI is of the view that the rise in costs is being borne by consumers and not companies.

“We expected this hike and are very happy that the RBI did what was to be done and did not let itself get swayed by market sentiments," said Indranil Pan, chief economist at Kotak Mahindra Bank Ltd. “With inflation close to 10% and showing no signs of easing, and with crude oil at $115 (aroundRs 5,463 today) per barrel, this was only a prudent move. They cannot afford to step aside and clear the channels for demand."

“At the moment, liquidity is good and credit offtake is not picking up. We don’t need to hike rates immediately, especially when we just increased our lending and borrowing rates," said M.D. Mallya, chairman and managing director (CMD) of Bank of Baroda and also chairman of the Indian Banks’ Association, the banking industry lobby.

“This hike was expected and was factored in by the market, so it will not have any impact on lending and borrowing rates," said Keki Mistry, vice-chairman and managing director at housing mortgage firm Housing Development Finance Corp. Ltd.

Canara Bank CMD S. Raman said he expects the policy lag “will be longer this time", and lending rates may not go up soon unless there is pressure on deposit rates.

V. Ashok, group chief financial officer (CFO) at Essar Group, said continuous increases in the cost of borrowings are beginning to affect profitability and, therefore, investments and growth, as evidenced by recent industrial production data. “The uncertain global economic scenario has already affected raising of capital and the macro business outlook. The further effect of all this will be reflected during the next financial year," he added.

According to Adesh Gupta, CFO of Grasim Industries Ltd and group executive president at the Aditya Birla Group, in the process of controlling inflation, growth is being sacrificed. “Despite the long battle that the central bank has undertaken, it seems like inflation cannot be controlled with demand-side measures alone. Credit offtake for corporate India has come down, and if this continues, soon there will be no takers," he said.

John Satish Kumar and PTI contributed to this story.