The Reserve Bank of India cut cash reserve requirements for banks by 50 basis points on Tuesday to ease tight liquidity, signalling a policy shift towards reviving growth after nearly two years of fighting inflation.

With core inflation still stubbornly high, the RBI as expected left its policy repo rate unchanged at 8.50 per cent for the second consecutive review.

The central bank had raised rates 13 times between March 2010 and October 2011, which made it one of the most hawkish central banks anywhere.

"The growth-inflation balance of the monetary policy stance has now shifted to growth, while at the same time ensuring that inflationary pressures remain contained," RBI Governor Duvvuri Subbarao said in his policy statement.

Bond and swap markets initially applauded the cut in the cash reserve ratio (CRR) before disappointment that there was not definitive guidance on a policy rate cut pushed bond yields and swap rates higher. The BSE Sensex, however, was sharply higher, rising as much as 1.66 per cent on the day, powered by bank shares.

"RBI has clearly said growth concerns have come center-stage despite lingering inflationary pressures," said Sumedh Deorukhkar, senior economist at BBVA in Mumbai, who expects a 25 basis point cut in the repo rate at the RBI's next review on March 15 and a combined 150 bps in cuts by the end of 2012.

Expectations had grown in recent days that the RBI would cut the cash reserve ratio, the share of deposits banks must hold with the central bank. The cut on Tuesday lowered CRR to 5.50 per cent and releases Rs 320 billion of liquidity into the banking system.

Inflation Worry Persists

The RBI kept to its hawkish stance long after most central banks shifted their focus to growth, as inflation in India remained high due to elevated food prices, infrastructure bottlenecks, and an expansionary fiscal policy that pushed up rural spending power and strained government finances.

Annual headline inflation, measured by the wholesale price index, slowed to a two-year low of 7.47 per cent in December, thanks to a sharp decline in food inflation.

However, manufactured product inflation edged up from the previous month, and the RBI said in a report on Monday that the two drivers of rate policy will be core inflation and the impact of exchange rate changes on inflation.

The 16 per cent drop in the rupee in 2011 has made imports even more expensive.

"Our sense is that the cut in cash reserve ratio is a reaction to the acute liquidity deficit that is persisting. As far as the inflationary situation is concerned, it has not materially changed apart from some softening in food prices," said Sujan Hajra, chief economist at Anand Rathi Securities.

Subbarao reiterated his call for more fiscal discipline from New Delhi, which is widely expected to fall far short of its deficit-cutting target for the current fiscal year.

"In the absence of credible fiscal consolidation, the Reserve Bank will be constrained from lowering the policy rate in response to decelerating private consumption and investment spending," Subbarao said in his report.

C. Rangarajan, chairman of the prime minister's Economic Advisory Council, told TV channels that the RBI should cut interest rates only when there are definite signs of non-food inflation easing.

As expected, the RBI lowered its GDP growth forecast for the fiscal year that ends in March to 7 per cent from 7.6 per cent, and left its wholesale price index inflation target unchanged at 7 per cent for the end of the fiscal year in March.

Asia's third-largest economy grew 8.5 per cent in the previous fiscal year. The RBI said it expected a "modest" recovery in growth in the fiscal year that starts in April, and said that while inflation may ease, price pressures persist.

"Upside risks to inflation arise from global crude oil prices, the lingering impact of rupee depreciation and slippage in the fiscal deficit," it said.

CRR Signal

Tuesday's CRR cut should be seen as a signal of easing intent, Subbarao said.

"The reduction can also be viewed as a reinforcement of the guidance that future rate actions will be towards lowering them," Subbarao said, adding that it was premature to cut the policy interest rate based on the current inflation outlook.

On Monday, Indian banks borrowed Rs 1.42 trillion from the RBI's repo window, more than double the Rs 600 billion that would indicate a liquidity deficit of 1 per cent. The RBI's guideline is for liquidity deficit or surplus within 1 per cent of aggregate deposits.

"Banks will now have access to more money. They might still do selective lending, but the environment will improve, which is right now fully chocked," Tapash Majumdar, chief financial officer at infrastructure builder C&C Constructions.

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