In a surprise move, the Reserve Bank of India has cut the key policy rate by 25 basis points, setting the tone for a reduction in lending rates by banks. This will prod banks to drop interest rates on home and car loans.

The policy repo rate under the liquidity adjustment facility (LAF) is cut by 25 basis points to 7.5 per cent from 7.75 per cent. The reduction will come into effect immediately.

The RBI has, however, kept the cash reserve ratio (CRR) of scheduled banks unchanged at 4 per cent of net demand and time liabilities (NDTL). It has said that it will continue to provide liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under seven-day and 14-day term repos of up to 0.75 per cent.

It has also decided to continue with daily variable rate repos and reverse repos to smooth liquidity. Consequently, the reverse repo rate under the LAF stands adjusted to 6.5 per cent, and the marginal standing facility (MSF) rate and the bank rate to 8.5 per cent.

Key factors

"While the next bi-monthly policy statement will be issued on April 7, 2015, the still weak state of certain sectors of the economy as well as the global trend towards easing suggests that any policy action should be anticipatory once, and sufficient data support the policy stance," the RBI said.

"With the release of the agreement on the monetary policy framework, it is appropriate for the Reserve Bank to offer guidance on how it will implement the mandate," the apex bank added. Going forward, the RBI will seek to bring inflation rate to a mid-point of the band of 4 per cent by the end of a two-year period starting fiscal year 2016-17.

Guidance stays

However, RBI said that the guidance on policy action given in the fifth bi-monthly monetary policy statement of December 2014 was largely unchanged. Further monetary actions, it said, would be conditioned by incoming data, especially on the easing of supply constraints, improved availability of key inputs such as power, land, minerals and infrastructure, continuing progress on high-quality fiscal consolidation, the pass through of past rate cuts into lending rates, the monsoon out-turn and developments in the international environment.

It may be recalled that in its statement on monetary policy of January 15, 2015, the Reserve Bank reduced the policy repo rate by 25 basis points and indicated that "key to further easing are data that confirm continuing disinflationary pressures. Also critical would be sustained high quality fiscal consolidation."

While maintaining the interest rate stance in its sixth bi-monthly monetary policy statement of February 3 in the absence of new developments on inflation or on the fiscal outlook till then, the Reserve Bank indicated that it would keenly monitor the revision in the consumer price index (CPI) with regard to the path of inflation in 2015-16 as well as the Union Budget for 2015-16.

Data developments

The new CPI re-based to 2012 was released on February 12, 2015. Inflation in January 2015, at 5.1 per cent as measured by the new index, was well within the target of 8 per cent for January 2015. Prices of vegetables declined, and inflation, excluding food and fuel, moderated in a broad-based manner to a new low. "Thus, disinflation is evolving along the path set out by the Reserve Bank in January 2014 and, in fact, at a faster pace than earlier envisaged," the RBI said.

"The uncertainties surrounding any inflation projection are, however, not insignificant. Oil prices have firmed up in recent weeks, and significant further strengthening, perhaps as a result of unanticipated geo-political events, will alter the inflation outlook. Other international commodity prices are expected to remain benign, given still-sluggish global demand conditions."

"Food prices will be affected by the seasonal upturn that typically occurs ahead of the south-west monsoon and, therefore, steps the government takes on food management will be critical in determining the inflation outlook. Finally, the possible spill over of volatility from international financial markets through exchange rate and asset prices channels is also channels was still a significant risk," it said.