India's central bank cut its policy repo rate by 25 basis points to 7.75 percent and reduced the cash reserve ratio (CRR) for banks by the same amount to 4.0 percent, citing tight liquidity conditions, saying inflationary pressures appear to have peaked and economic activity remains subdued.
The Reserve Bank of India (RBI), which cut its benchmark repurchase rate by 50 basis points in 2012, said it was likely that inflation would remain range-bound around the current level in 2013-14 and this would allow it to focus on supporting growth. The growth forecast was revised downward.
"This provides space, albeit limited, for monetary policy to give greater emphasis to growth risks," the RBI said in its third quarter policy review, citing the bank's governor Dr. D. Subbarao.
"This policy guidance will, however, be conditioned by the evolving growth-inflation dynamic and the management of risks from the twin deficits," he added.
Financial markets had expected the RBI to cut its repo rate due to weak growth, waning inflationary pressures and the bank's statement in December that lower inflation would allow it to support growth.
The cut in the CRR should inject around 180 billion rupees into the banking system, RBI said. Other key rates, such as the reverse repo rates was cut to 6.75 percent, the marginal standing facility and the bank rate to 8.75 percent.
The RBI already trimmed the cash reserve ratio in September and October last year and injected 470 billion rupees of liquidity into the banking system during December and January, but the bank said average borrowing from the its liquidity adjustment facility (LAF) of 910 billion in January have been above the bank's comfort level.
"This tightness could potentially hurt credit flow to productive sectors of the economy," Subbarao said.
In July the RBI projected Gross Domestic Product growth of 6.5 percent for the current 2012-13 year of 6.5 percent, but this was revised down to 5.8 percent in October and has now been revised further down to 5.5 percent as investment activity has been weak and policy initiatives by the government will take some time to reverse the investment slowdown and reinvigorate growth.
Globally, sluggish global economic conditions prevail but "overall, global economic prospects have improved modestly since the Reserve Bank's last review in October 2012 even as significant risks remain," the bank said.
In the third quarter of 2012, India's GDP expanded by only 0.6 percent from the previous quarter for annual growth of 5.3 percent, down from a 5.5 percent growth rate in the second quarter.
India's main measure of inflation, the wholesale price index, eased to 7.18 percent in December from 7.24 percent in November due to the a sharp drop in the prices of non-food manufactured products. The bank's survey also pointed to a softening of industrial output prices, suggesting that the pricing power of corporates has weakened.
Food inflation, however, was contrary, moving into double digits, reflecting cyclical and structural factors, which will keep the headline inflation rate around current levels.
With demand pressures ebbing, the RBI called for an urgent solution to remove supply constraints and tackle India's inflation which accelerated in late 2009 to over 10 percent in mid-2010 and remains over the central bank's 4-5 percent comfort zone.
"In the absence of an effective supply response, inflationary pressures may return and persist with adverse implications for macroeconomic stability," the RBI said.
The bank revised downward its March forecast for WPI inflation to 6.8 percent from October's 7.5 percent.