The central bank said in a statement that it would raised its overnight repurchase rate by 25 basis points to 8.75 percent and the reverse repurchase rate by the same amount to 10.25 percent.

"A deceleration in monetary expansion and a further containment of inflation and inflation expectations are expected with these measures," the statement said.

The repurchase rate is the return on cash deposited by commercial banks with the central bank and the reverse repurchase rate is the cost of borrowing from the central bank.

Investors said the move came as a surprise because inflation in the island nation had shown signs of slowing down with the latest figures showing a 12.1 percent rise in November from a peak of 12.8 percent in August.

For the year ended November, inflation averaged 9.1 percent.

"The rate hike appears to be a pre-emptive strike," Chief Investment Officer of Boston Asset Management Channa Amaratunga said.

However he said money supply growth remains high, fuelled by demand for credit and higher foreign currency inflows.

Real interest rates, defined as the rate of return minus inflation, in Sri Lanka have been negative until recently, making monetary policy measures ineffective.

But analysts say the latest rise would help the central bank regain a small measure of control, especially after the recent issue of inflation-linked bonds.

The government recently converted part of its overdraft with two state-owned commercial banks to 220 million dollars in bonds, which if sold out of the banking sector, is also expected to help reduce money supply growth.

The three-year issue, carries a 11.2 percent coupon rate in the first year. The coupon rate is pegged at one percentage point above the country's annual inflation rate for the remaining two years.

"Now that the government has issued an inflation-linked bond, they will be careful to control inflation," says Dudeepa Ratwatte, chief executive of First Capital Asset Management.

The central bank has forecast year-end inflation of around 10.0 percent, which is the highest in South Asia.

Analysts say inflation in the tropical island, torn by ethnic conflict and with the coastline devastated by last December's tsunami, has been fuelled by an expansionary fiscal policy in 2004 and not enough tightening of monetary policy in the face of capital inflows in 2005.

Also of concern to investors and the central bank is the 2006 federal budget by new President Mahinda Rajapakse's that increased subsidies for farmers.

Rajapakse, who is also the country's finance minister, incorporated spending promises made during his election campaign, by raising welfare benefits and fertiliser subsidies under a revised 2006 budget released earlier this month.

He said the budget deficit will widen to 9.1 percent of gross domestic product next year, from a forecast of 8.5 percent of GDP this year.

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