The Reserve Bank of India (RBI) surprised markets with a 25 basis point reduction in interest rates and signalled it could cut further, amid signs of cooling inflation and what it said was a government commitment to contain the fiscal deficit.
While the early move was unexpected, aggressive reductions in rates have been seen as likely over the course of the coming year to help India's economy out of a rut, with growth rates struggling to recover from their weakest levels since the 1980s.
Tumbling oil prices and lower food costs have hardened speculation that more reductions in rates will follow, as recent data showed subdued consumer and wholesale price increases. Acting ahead of a scheduled RBI policy meeting on Feb 3 and the government's annual budget statement in late February, the RBI cut the repo rate - its key lending rate - to 7.75 per cent from 8 per cent, where it had been for the past year.
As a result, the reverse repo rate, the rate at which the central bank drains excess liquidity from the banking system, also moved down by 25 basis points to 6.75 per cent. "This demonstrates RBI’s confidence in the evolving inflation outlook and it shows that they are putting faith in government's fiscal consolidation plan," said Radhika Rao, economist at DBS Bank Ltd.
Investors saw RBI Governor Raghuram Rajan putting India on a new easing cycle, as the former International Monetary Fund chief economist ordered his first rate cut since being appointed in August 2013.
Finance Minister Arun Jaitley, who earlier this week had said the time was right for lower rates, welcomed the cut and said it would help revive capital investments. The early rate reduction now puts the onus on the government to make credible efforts to contain the fiscal deficit while pursuing policies aimed at boosting investment and improving infrastructure to fire up the economy.
In its statement, the RBI said "high quality" fiscal consolidation and reforms to power, land, minerals and infrastructure would be "critical" to more cuts.
India's stock market was the second best performer in Asia last year in dollar terms, due to investors' hopes that Prime Minister Narendra Modi would push reforms needed to unlock India's growth potential following his landslide election last May.
India has posted sub-5 per cent growth rates in its previous two financial years, levels far too slow for a country with its demographic challenges.
Subsiding inflation pressures
Data released showed retail inflation rose to 5 per cent in December - below the 5.4 per cent annual rise predicted by a poll. The RBI expects retail inflation will hit 6 per cent in March and targets a level of below that from January next year. Some analysts believe Rajan may have come under pressure from the government to lower interest rates sooner than he would have ideally chosen.
"This is a surprise move in the middle of the war on inflation," said N.R. Bhanumurthy, a New Delhi-based economist at the National Institute of Public Finance and Policy.
"I am very surprised because it goes against the whole current governor’s philosophy that monetary policy should be predictable. It shows the governor is very pragmatic and can look at his own position and can change."
