Bond yields, which have been moving to factor in India's sixth rate rise this year, ticked higher on the comments from Deputy Governor Subir Gokarn, who said structural changes in the emerging economy could have an adverse impact on inflation and inflation expectations.
"Persistent price increases in commodities for which there are less effective substitutes, with other things remaining equal, will raise the potential rate of inflation over a period of time," Gokarn said in a speech.
"This means that actual inflation or interest rates will be higher than they would be in the absence of such increases," said Gokarn, whose brief at the RBI includes monetary policy.
Still, the finance ministry urged the RBI not to choke off the country's growth. It said in a report on Tuesday that GDP could rise 8.5% to 9.7% in the fiscal year to the end of March 2011.
"It has to be ensured that monetary tightening does not adversely affect the pace of recovery at this stage," the Finance Ministry wrote in the report.
The RBI is widely expected to raise interest rates by 25 basis points on Nov. 2 as it battles wholesale inflation that has been persistently above its perceived comfort zone of 5 percent to 6 percent. The RBI has forecast inflation will ease to 6 percent by March.
The wholesale price index, India's main inflation measure, rose by 8.62% in September over a year earlier.
After the central banker's comments the yield on the benchmark 10-year bond rose 5 basis points to 8.18%.
The 10-year yield has been rising since the start of this month and touched a 25-month high last Thursday as dealers priced in the risk of a rate rise.
Concerns that India is struggling to bring inflation under control has led to a reversal in the flattening of the interest rate swap curve over the past two weeks.
Traders now expect the spread between 5-year swap rates and 1-year swap rates to widen to 55-60 basis points, led by a rise in the long end, from 48 basis points on Tuesday as the market prices in the potential for policy rates to rise 50-75 basis points by the end of March.
Two weeks ago, traders were pricing in a greater chance of a pause in rate hikes after December. However, after the September inflation release, they now expect the rate tightening to continue through March.
Food inflation
Annual food price inflation was 15.53% in early October and has remained stubbornly high, in part a reflection of rising incomes in the fast emerging economy.
"When we take into consideration the impact of structural food price shocks such as the ones India is experiencing, the policy implications become complex," Gokarn said.
He cited the example of pulses, a main source of protein in the Indian diet. The price of some pulses has roughly doubled in the past three years as production has failed to keep pace with a rise in demand.
"Rise in income has increased the share of proteins in peoples' diet. Rising affluence has also led to an increase in demand for proteins and nutrition," Gokarn said.
Gokarn said the conventional view suggested monetary tools would have no impact in combating a rise in food prices due to temporary supply disruption. Indeed, it could hurt economic growth prospects.
"However, if the economy is at or close to capacity utilisation, even temporary price shocks can aggravate inflation expectations, which may justify monetary response even though shock is temporary and will die out before the actions take effect," he said.
The RBI has raised interest rates five times this year, taking the repo rate to 6% and the reverse repo rate to 5%, to control inflation, which was in double-digits for six months through July.
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