MUMBAI The Reserve Bank of India (RBI) cut its policy interest rate by 25 basis points to 6.50 percent on Tuesday, reducing it to a more than five-year low while dangling the prospect of another cut later this year if inflation trends stay benign.
To make policy rate cuts more effective, the RBI also took steps to ensure increased liquidity in the financial system, as banks had cited tight cash conditions as a reason for not cutting their lending rates by more earlier.
The combined moves signalled a new approach by Governor Raghuram Rajan, who was disappointed that the RBI's aggressive easing last year failed to have the impact he had hoped for due to commercial banks reluctance to lower rates for borrowers.
Addressing a news conference following the policy review, Rajan voiced confidence that banks would take heed this time.
"Borrowing rates are coming down significantly in this economy," Rajan said. "My hope is that we will see significantly more transmission over the next few months."
Controlling inflation is the central bank's priority, but Prime Minister Narendra Modi's government would welcome any move to improve business conditions for industrialists who, despite data depicting India as one of the world's fastest growing economies, remain hesitant to invest.
India's annual economic growth slowed to 7.3 percent in the October-December quarter from 7.7 in the previous quarter, below the 8.0 percent growth needed to generate jobs for the millions of Indians joining the workforce each year. [nL4N11V4EY]
Although rates are now at the lowest since 2011, the RBI said its policy would remain "accommodative", raising the prospect of another 25 bps rate cut later this year, saying inflation was moving towards its 5 percent target in March 2017. Its next target will be 4.2 percent by March 2018.
The benchmark 10-year bond fell as much as 9 basis points to 7.34 percent after the rate cut was announced, but shares fell, with the NSE index .NSEI down 0.8 percent.
Prospects for a further rate reduction could hinge on global oil price trends, the impact of the monsoon rainy season on food prices, and how a planned wage hike for millions of government employees feeds through to inflation. The RBI said it would be monitoring those developments.
Most analysts had anticipated the latest reduction after inflation slowed to 5.18 percent in February and the government's 2016/17 budget kept borrowing and spending in check.
The RBI had cut its repo rate by 125 basis points last year, but banks, complaining of tight cash conditions, have only lowered their lending rates by around 60 bps, preventing the RBI's easing from fully feeding through to the broader economy.
Ensuring banks pass on those rate cuts, helping spur private investment, is now seen as a vital plank to boost the economy.
"Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates," the RBI said.
This month, the RBI had already invoked new rules forcing commercial banks to set lending rates based on prevailing market rates.
To give banks more comfort, the RBI reduced the cash proportion of banks' reserve requirements that must kept with the central bank, while also pledging to inject more long-term liquidity.
And as part of a balancing act to reduce the risk of cash flooding the system, the RBI also unexpectedly raised the reverse repo - or the rates lenders charge to the central bank - by 25 basis points to 6.0 percent.
The RBI said it would inject more "durable" liquidity over the next 12 months by buying bonds via open market operations or by buying dollars and selling rupees every month.
"Today's decision was more focused on addressing liquidity shortage and easing the transmission mechanism," said Radhika Rao, an economist for DBS Bank in Singapore.
"This is to ensure that the easy policy stance percolates to the real economy and materially lowers financing costs."
(Additional reporting by Mumbai bureau; Editing by Simon Cameron-Moore)
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