It is the second consecutive rate rise by the Reserve Bank of India (RBI), which raised its policy rate by 25 basis points in September, thus reversing cuts earlier this year and leaving the policy rate 25 points below its level at the start of 2013.
"It is important to break the spiral of rising price pressures in order to curb the erosion of financial saving and strengthen the foundations of growth," the RBI said, quoting Raghuram Rajan who took over as governor in early September.
The RBI cut its MSF rate, or the overnight borrowing rate, in September by 75 basis points as part of its move to unwind exceptional tightening measures taken in July.
"With the reduction of the MSF rate and the increase in the repo rate in this review, the process of realigning the interest rate corridor to normal monetary policy operations is now complete," Rajan said.
The MSF rate was raised by 200 basis points in July as part of the central bank's defense of the rupee which plunged as capital started to flow out of India and other major emerging markets in expectation that the U.S. Federal Reserve would start to reduce its asset purchases.
At today's second quarter policy review, the RBI kept the cash reserve ratio (CRR) steady at 4.0 percent but also increased the liquidity provided through 7-day and 14-day repos from 0.25 percent of Net Demand and Time Liability (NDTL) of the banking system to 0.5 percent. The bank also adjusted the reverse repo and bank rates to 6.75 percent and 8.75 percent, respectively.
Looking ahead, the RBI said it would "closely monitor inflation risk while being mindful of the evolving growth dynamics."
The decision by the RBI was widely expected given the continuing rise in inflation.
Inflation, as measured by wholesale prices - India's preferred gauge - rose to 6.46 percent in September, the fourth month in a row of rising prices, from 6.1 percent in August, well above the RBI's medium-term objective of annual inflation of 3.0 percent and the short-term goal of 5.0 percent WPI inflation by March 2014.
Rajan said the pass-through of rupee depreciation into prices of manufactured products is partly offsetting the disinflationary effects of low growth and while food prices may ease with the harvest, "overall WPI inflation is expected to remain higher than current levels through most of the remaining part of the year, warranting an appropriate policy response."
In its policy report, the RBI said a study of professional forecasters expect the average WPI inflation to rise to 6 percent from an earlier expectation of 5.3 percent.
Although the depreciation in the rupee is impacting inflation, the rupee has recently stabilized as capital flows have resumed following the Fed's decision to postpone the tapering of asset purchases.
Since early September the rupee has rebounded and been stable in the last month, rising to 61.51 to the dollar today from 68.15 on September 4, a rise of almost 10 percent. But compared with the end of last year, the rupee has still lost almost 11 percent, putting upward pressure on inflation.
"Nevertheless, headwinds to growth from domestic constraints continue to pose downside risks, and vulnerabilities to sudden shifts in the external environment remain," Rajan said, adding that the outlook for global growth had improved modestly since September with fiscal concerns abating in the U.S. and indicators of activity firming up in the euro area and the United Kingdom.But industrial activity in India has weakened, reflecting the ongoing downturn in both consumption and investment demand.
Stronger exports and signs of a revival in some services, along with an expected pick-up in agriculture, could support higher growth in the second half of financial year 2013/14 from the first half, raising real GDP growth to 5.0 percent for the year as a whole from 4.4 percent in Q1, Rajan said, adding that a revival of large stalled projects may also buoy investment and activity.
India's 2013/14 financial year began April 1.
India's Gross Domestic Product expanded by 4.4 percent in the second calendar quarter of the year, down from 4.8 percent in the first quarter and continuing a trend since the first quarter of 2010 of declining growth rates.