India’s central bank took markets by surprise on Wednesday when it left key interest rates unchanged in spite of sharply higher inflation.

“The policy decision is a close one,” Raghuram Rajan, governor of the Reserve Bank of India, said in a mid-quarter policy review, insisting he had not gone “soft” on inflation.

He acknowledged there were risks in keeping rates steady and waiting for more data, “including the possibility that tapering of quantitative easing by the US Fed may disrupt external markets and that the Reserve Bank may be perceived to be soft on inflation”.
The Federal Reserve’s open market committee meets later on Wednesday to decide whether to start to taper the $85bn it is spending each month on buying US bonds.

Mr Rajan conceded India’s current inflation was too high. “However, given the wide bands of uncertainty surrounding the short-term path of inflation from its high current levels, and given the weak state of the economy. . .there is merit in waiting for more data.”

Investors had expected Mr Rajan to continue raising rates in an attempt to stifle inflation, but the bank left the policy repo rate unchanged at 7.75 per cent. Cash reserve ratios for banks were also left unchanged. The Sensex index rose more than 1 per cent immediately after the release, with bank stocks up 2 per cent.

Indian consumer price inflation, stoked by sharp rises in the price of vegetables and other foods, rose to 11.2 per cent in November, the highest among major emerging economies. The wholesale price index also increased in the same month to 7.5 per cent.

Mr Rajan said the RBI would remain vigilant and take action on rates – even on days when no policy move was scheduled – if food price inflation did not soften as expected.

“I think what we’re saying is we will not react to every spike in inflation that is temporary,” Mr Rajan told a news conference, adding that vegetable prices surveyed in urban areas appeared to be falling sharply while the recovery of the rupee against the US dollar had also eased inflationary pressures. “I want to emphasise we are not being soft on inflation. We are waiting for data.”

Daniel Martin, Asia economist of Capital Economics, said Indian interest rates would probably now stay on hold for some time.

He said in a note after the announcement: “Given that the economic recovery is still very fragile, we think the RBI will be patient with inflation. As long as it starts to come down at the start of next year, more rate hikes are unlikely. Indeed, there should be some scope for the RBI to start easing in late 2014.”

With economic growth having halved over the past two years to less than 5 per cent a year, some economists have been warning that India risks “stagflation”, an uncomfortable mix of low growth and high inflation.

“India’s 2013 economic performance has been disappointing and little on the horizon is likely to lift growth,” Moody’s Analytics said in a report on Tuesday.