March 30 (Bloomberg) -- India's central bank raised a key interest rate a month before its scheduled policy review because of a failure to bring down inflation from a near two- year high.

The Reserve Bank of India increased its overnight lending rate by a quarter percentage point today to a 4 1/2 year high of 7.75 percent. The Mumbai-based bank also raised banks' reserve requirements for the third time since December, and said it is shifting policy away from balancing inflation with economic growth to focusing solely on prices.

Governor Yaga Venugopal Reddy has raised borrowing costs six times in 14 months to curb record bank lending and tackle inflation, which has stayed a percentage point above the bank's highest estimate. In the past two weeks, overnight borrowing costs rose to the highest in at least a decade and the rupee rallied to an eight-year high, as Reddy's actions squeezed cash from the banking system.

``The central bank is overdoing it to curb inflation,'' said Rajeev Malik, senior economist at JPMorgan Chase & Co. in Singapore. ``After the aggressive policy tightening so far, one would have thought the central bank would wait for some time to see their impact on inflation. This move will hit growth.''

Analysts Surprised

Analysts have been surprised three times since December by Reddy's actions, inviting criticism from companies including Hero Honda Motors Ltd. Borrowing costs in the overnight money market rose to the highest in at least a decade after companies paid their quarterly tax, forcing banks to sell dollars to replenish cash holdings. This sent the rupee to the highest in almost eight years on March 28.

Bankers and industry officials said Reddy has abandoned the central bank's policy of keeping a firm check on volatility in the rupee-dollar market and allowed the currency to appreciate so that costs of imports would be lowered, in turn reducing inflation.

``The central bank is looking at the rupee as a second instrument to rein in inflation, and that is why it is accepting the volatility,'' said Prabal Banerji, chief financial officer at Hinduja Group in Mumbai, which has businesses in banking, automobiles and entertainment.

The yield on the benchmark 10-year government bonds climbed 39 basis points to 8 percent this quarter as the central bank raised the cost of money and sold bonds to mop liquidity in its battle against inflation.

Reserve Ratio

The Reserve Bank increased the repurchase rate at which it lends overnight to 7.75 percent from 7.5 percent with immediate effect. It raised the cash reserve ratio to 6.5 percent from 6 percent in two stages starting April 14.

Reddy has raised the key overnight lending rate since January 2006, and increased the cash reserve ratio since December to slow loans that have grown at an average 30 percent since 2004, the fastest pace since the central bank started collating data in 1971.

``In the light of the current macroeconomic, monetary and anticipated liquidity conditions, and with a view to containing inflation expectations, it is critical to take demonstrable and determined action on an urgent basis,'' the central bank said in its statement.

The benchmark wholesale price inflation has held at near a two-year high of 6.46 percent for three weeks ending March 17, the government said.

`Strong Psychological Impact'

``With today's action, the RBI has clearly left no room for anyone to think that they're done with monetary tightening,'' said Mahendra Jajoo, who manages the equivalent of $1.2 billion of Indian debt at ABN Amro Asset Management Ltd. in Mumbai. ``This is going to have a strong psychological and physical impact on the bond market. The 10-year bond yield may rise by as much as 25 basis points after this.''

Finance Minister Palaniappan Chidambaram assured lawmakers this month in parliament that the central bank will continue to take monetary action to curb inflation. Chidambaram wants to tame inflation at the earliest as he faces criticism from his Congress party for losses in two state elections last month.

Reddy said the central bank has shifted toward a tougher stance on tackling rising prices and is less concerned about the impact on the world's second-fastest pace of economic growth.

`Policy has Shifted'

``The stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability with immediate monetary measures and to take recourse to all possible measures promptly in response to evolving circumstances,'' the RBI said.

Chidambaram has over the past year often called for benign interest rates in the economy even as the central bank has raised the repurchase rate. Chidambaram sought lower interest rates to spur investment sustain the country's record 8.6 percent expansion since 2003, the fastest pace since the country's independence in 1947.

The record economic expansion has spurred Bombay Stock Exchange's Sensitive index to rise four times to a record since March 2003, led by companies such as Reliance Industries Ltd.

``Liquidity was anyway tight and this step has tightened liquidity even further,'' said A. Balasubramaniam, who oversees the equivalent of $3.7 billion as chief investment officer at Birla Sun Life Asset Management Co. in Mumbai. ``Both the bond and the stock markets will react negatively to this move. Banks will have to raise rates.''

Manufacturer's Complain

Hero Honda, India's biggest motorcycle maker, said sales growth is slowing because rising interest rates are discouraging consumers.

``Sales in March is likely to be flat because of the steep jump in interest rates,'' said Ravi Sud, Hero Honda's chief financial officer. ``The motorcycle market is slowing down.''

ICICI Bank Ltd., India's biggest lender by market value, said this month it expects retail loan growth to slow after it raised rates last month for the third time since December.

``Inflation crossing 6 percent is a matter of concern at this juncture,'' Reddy said at a seminar today in Cernobbio, Italy, according to the central bank's website. ``The common intention of the government and the Reserve Bank of India is to maintain annual inflation below 5 percent in the medium term.''

To contact the reporter on this story: Cherian Thomas in New Delhi at cthomas1@bloomberg.net.

Last Updated: March 30, 2007 12:09 EDT