India has raised its short-term interest rate to its highest level since March 2003.
The Indian economy experienced strong growth in 2006
The central bank raised the cost of borrowing by a quarter of a point to 7.5%, but left other rates unchanged.
Policymakers said they had raised rates in a bid to curb inflation, which is significantly above targets at 6.1%.
The bank added it hoped the move would not hit growth, as it raised forecasts for economic expansion in the current financial year for a second time.
The central bank now expects growth for 2006/2007 of between 8.5% and 9% - compared with previous forecasts of 8%.
The economy grew 9.1% in the first half of the year to September driven by surging output from the agricultural sector, the Central Statistics Organisation said.
"Demand pressures appear to have intensified, reflected in rising inflation, high money and credit growth, and elevated asset prices," the central bank said.
It also warned about rising house prices and the surge in credit growth, which it wants to see reined in.
As a result, the central bank's move was a warning shot to the financial sector that it must "must moderate credit growth", finance minister Palaniappan Chidambaram said.
"Monetary policy takes some time to work...it would have a favourable impact on bringing down inflation," Mr Chidambaram added.
The government has also taken measures to try to combat inflation by cutting import duty on edible oils, steel and cement.