Prices of benchmark 10-year bond fell to its lowest in more than 16 months on Wednesday after unexpectedly high consumer inflation in November raised fears the central bank could hike interest rates sooner than had been expected.

The benchmark 10-year bond yield was up 3 basis points at 7.22 per cent by 0443 GMT after rising to as high as 7.25 per cent, the highest since July 2016, as bond prices fell. The bond price falls followed data out late on Tuesday showing annual inflation accelerating to a 15-month high of 4.88 percent in November, driven by a surge in food prices.

That rate was sharply above the Reserve Bank of India's 4 per cent medium-term inflation target and its projection that inflation would accelerate to between 4.3 and 4.7 percent in the six months to March. A Reuters poll had forecast inflation of 4.2 percent in November.

Worryingly, core inflation last month also accelerated, hitting 4.9 per cent from an average of 4.3 per cent over the prior six months, according to DBS Bank estimates, driven by India's dominant services sector.

Analysts said they still expected the RBI to hold its repo rate at a more than 7-year low of 6.00 per cent after last cutting it in August, but warned that the odds of a hike had risen. The central bank could also shift to a tightening bias from its current neutral stance, they added.

The RBI's monetary policy committee (MPC) holds its next policy meeting in early February. “We now see 30 per cent chance of a precautionary rate hike in the February policy (meeting) itself, with the MPC facing an acute trade-off between sluggish growth and rising inflation for the first time in its short existence,” Citigroup said in a note to clients on Wednesday.

Reaction in other markets was more muted, with the NSE share index up 0.4 per cent. The partially convertible rupee was trading at 64.45 per dollar versus its previous close of 64.40. The currency follows foreign-exchange flows and share prices.

Not an easy call

Raising interest rates won't be an easy call for the RBI. Although annual economic growth recovered to 6.3 per cent in July-September, halting a five-quarter slide, it is still below the 8 per cent India needs to create enough jobs for the millions of youth joining the workforce each year.

Data on Tuesday also showed that annual industrial output grew a lower-than-expected 2.2 per cent in October, falling short of a forecast 3.0 per cent.

Any rate hikes could also raise opposition from government officials, who have been calling for rate cuts to aid an economy badly hit by last year's shock move to remove high-denomination bills from circulation and by uncertainty around a new national sales tax this year. It could also raise questions about the RBI's inflation mandate.

Under major reforms first unveiled in 2015, the central bank's newly-constituted MPC is meant to keep inflation in a range of 2 to 6 per cent but has faced criticism for effectively adopting the midpoint of 4 per cent as its primary target. The RBI took advantage of an extraordinary period of low inflation, including a slump in food and energy prices, to cut rates by a total of 200 basis points from January 2015 until August, the longest easing cycle since the 2008 global financial crisis.

For bond investors the inflation data is the latest negative news in a tough year: The 10-year bond yield has risen more than 70 bps since June, and the bond is headed for its first annual price fall in four years. Besides inflation, bond investors have fretted that the government will have to widen its fiscal deficit target of 3.2 per cent for the year ending in March, leading to increased borrowing from bond markets.

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