India's central bank began to wind up its recent exceptional measures aimed at shoring up the embattled rupee currency, raising the policy rate by 25 basis points to combat inflation while cutting the marginal standing facility (MSF) rate by 75 basis points to ease short-term liquidity conditions.
The Reserve Bank of India (RBI), which saw the rupee plunge from May through August, also cut the minimum daily maintenance of the cash reserve ratio (CRR) to 95 percent from 99 percent while keeping the overall CRR rate unchanged at 4.0 percent.
The repo rate under the liquidity adjustment facility (LAF) was raised to 7.50 percent from 7.25 percent, reversing some of the RBI's rate cuts earlier this year when it was seeking to boost growth. The RBI has now cut its policy rate by a net 50 basis points this year.
As a consequence, the reverse repo rate under the LAF is adjusted to 6.5 percent and the Bank Rate down to 9.5 percent so the MSF and bank rate are recalibrated to 200 basis points above the repo rate.
"We believe that easing the exceptional liquidity measures was warranted given that the external environment has improved and given that the government and the RBI have used the time since the measures were put in place to narrow the current account deficit and ease its financing," the new governor of the RBI, Raghuram Rajan, said.
The RBI raised the MSF rate - the rate at which banks access funds for emergency needs - by 200 basis points in July as part of a series of tightening measures aimed making the rupee more attractive.
Following news that the U.S. Federal Reserve was planning to reduce its asset purchases in the second half of this year, the rupee depreciated by some 20 percent from early May through August as investors adjusted their global portfolios.
Helped by a string of tightening measures, the rupee bounced back in late August and was trading at 62.6 to the U.S. dollar today compared with 68.6 in late August.
As part of the RBI's exceptional tightening measures, the MSF became the central bank's effective policy rate but Rajan wants the repo rate to return to its role as the effective policy rate as policy slowly returns to more normal conditions.
"Recognizing that inflationary pressures are mounting and determined to establish a nominal anchor which will allow us to preserve the internal value of the rupee, we have raised the repo rate by 25 basis points," Rajan said.
The exceptional tightening measures, coupled with the Federal Reserve's decision this week to delay a tapering of quantitative easing, has given the RBI some breathing room, but Rajan also cautioned that the "postponement of tapering is only that, a postponement."
India's inflation rate has started accelerating as the pass-through of fuel price increases has been compounded by the sharp depreciation of the rupee and rising international commodity prices.
India's wholesale inflation rate - the RBI's preferred inflation gauge - rose to 6.1 percent in August from 5.79 percent in July. The RBI aims to maintain WPI inflation at 5.0 percent by March 2014 while it's medium-term objective is to keep it at 3.0 percent.
"As the inflationary consequences of exchange rate depreciation and hitherto suppressed inflation play out, they will offset some of the disinflationary effects of a better harvest and the negative output gap," the RBI said.
But while inflation is rising, India's economic growth is weakening with continuing sluggishness in industrial activity and services, the pace of infrastructure project completion is subdued and new project starts are muted, the RBI said.
"Consequently, growth is trailing below potential and the output gap is widening," the RBI said.
In the second half of the fiscal 2013-14 year, growth could pick up as infrastructure projects are expedited and the government approves investments, it added.
India's annual growth rate fell to 4.4 percent in the second quarter of 2013, the 14th quarter in a row with a falling growth rate.