By Rajesh Kumar Singh
NEW DELHI (Reuters) - India's headline inflation shot to a six-month high in August, driven by a 245 percent annual jump in onion prices, hardening the case for Reserve Bank of India (RBI) governor Raghuram Rajan to keep interest rates high at his first policy meeting later this week.
Food inflation accelerated to a three-year high of 18.18 percent in August, government data released on Monday showed, driving the benchmark Wholesale Price Index up by a stronger-than-expected 6.1 percent.
Economists had expected a slight pick-up to 5.8 percent from 5.79 percent in July.
Monday's data is a grim reminder of the economic pressures facing the new central bank governor as he steps in to deal with India's worst economic crisis in more than 20 years.
Rajan has already warned he does not have a "magic wand," but as he has been dubbed "The Guv" by a gushing Indian media hopes are high that he can find a formula to calm inflationary pressure, stabilise the rupee and at the same time spark a revival in economic growth.
The higher inflation number dampened market expectations that Rajan would begin to rollback some of the measures put in place by his predecessor in a bid to arrest a sharp fall in the rupee since May. Those steps included draining liquidity from the banking system.
The rupee, stocks and bonds all pared earlier gains after the data, with the rupee trading at 62.70 to the dollar as of 1500 IST, up about 1.3 percent on the day but still down more than 12 percent so far this year.
The benchmark BSE Sensex and the broader Nifty both turned slightly lower, while bonds also reversed earlier gains.
However, some economists were comforted by the small increase in prices for manufactured products.
"From a policy-making stand point, we expect RBI to be more objective as manufacturing sector inflation still seems to be contained and they shouldn't react to the higher food inflation number," said R Sivakumar, head of fixed income, at Axis Mutual Fund in Mumbai.
GRAPHIC: India CPI and WPI http://link.reuters.com/zar28t
Onions are a staple ingredient in many Indian dishes and rising prices of the vegetable anger voters and can quickly become a political issue. India is due to hold its largest-ever general election within eight months.
Onions cost 245 percent more in August than a year before, while other vegetables shot up by 77 percent. Eggs, meat and fish were up nearly 19 percent.
"Every day I am making meals using only one small onion, half for the morning meal and another half for dinner," said Santilata Behera, 34, a labourer who supports a family of three and has cut her onion buying to half a kilogram per month.
Farmers are expecting food prices to start moderating from October onwards as supplies rise from crops planted after the much better monsoon season. However, heavy rainfall has resulted in flooding in some areas of the country making it difficult to get produce to market.
More price pressure could come in the form of a government plan to hike retail fuel prices by nearly 10 percent to ease its oil subsidy burden, which has risen after the rupee's fall and on higher crude prices.
Analysts estimate that such an increase in diesel prices would directly add 0.5 percent to headline inflation.
That will only make Rajan's job more difficult because measures to stifle inflation, such as raising interest rates, could at the same time undermine economic growth, already strained and running at a decade low.
Before he reveals his monetary stance, Rajan will have to first deal with the outcome of a pivotal meeting on Tuesday and Wednesday of the U.S. Federal Reserve.
The Fed is likely to announce measures to rein in its massive economic stimulus. Fears of an expected policy tapering have already sparked an emerging market sell-off, contributing to the rupee's fall to record lows last month.
The rupee performed better on Monday thanks to a weaker dollar after Lawrence Summers, seen as relatively hawkish on monetary policy, withdrew from the race for the next Fed chief, thus raising prospects that the U.S. central bank will keep policy loose for longer.
The Fed is expected to reduce its $85 billion a month bond-buying programme this week, but financial markets are uncertain about the extent of the reduction.
Concerns that India, along with other emerging markets, will see reduced capital inflows and possibly even outflows once the Fed trims its stimulus programme have been a major factor in the rupee's slump.
Robert Prior-Wandesforde of Credit Suisse reckons Rajan could avoid a hike in interest rates on Friday unless the Fed decisions change his plan. Prior-Wandesforde said Rajan will likely express a commitment to keep liquidity tightening measures in place.
"In our view, anything that suggests he wants to remove these measures would risk undermining the rupee once again," he wrote in a note after Monday's inflation data.
(Additional reporting DELHI bureau and MUMBAI markets and treasury teams; Editing by Kim Coghill)