BANGALORE/NEW DELHI (Reuters) – India's manufacturing sector expanded at its fastest rate in over two years in May, bolstered by steady growth in output and new orders, reinforcing expectations of a further hike in interest rates late next month.

Automakers also posted sharp sales growth for May, although stocks dropped more than two percent on fears that Europe's debt problems would hurt fund inflows from foreign investors and potentially derail the global economic recovery.

Many economists and traders expect worries about the euro zone debt crisis will keep the Reserve Bank of India (RBI) from raising its policy rates before its next quarterly review on July 27, as some market watchers had earlier predicted.

But the central bank is still expected to raise rates by 25 basis points at the July meeting as it struggles to contain mounting price pressures. It has already increased rates by 50 basis points since mid-March.

"Inflation is not at peak level. It is still higher than we would like it," RBI Governor Duvvuri Subbarao said yesterday.

Monsoon rains arrived in southern India on time on Monday, and policymakers will keep watch on how the rainy season pans out after last summer's drought sent food prices sharply higher.