While RBI "shifted" the policy stance from inflation to growth which faces downside risks, borrowers reeling under high interest rates can draw solace from the announcement that "future rate actions will be towards lowering them".

However, the interest rate cut (repo rate) would depend on the government disciplining its expenditure, RBI said.

In its third quarterly review of the monetary policy, RBI kept the short-term lending rate (repo) unchanged at 8.5 per cent. It also did not alter bank rate of six per cent.

Addressing concerns over decelerating growth, upside risks to inflation and tight liquidity conditions, the central bank has left banks with more resources for lending through CRR cut, which will come into effect from January 28.

Despite a sharp reduction in food prices, RBI took a cautious view and refrained from reducing interest rates.

"Based on the current inflation trajectory, including consideration of suppressed inflation, it is premature to begin reducing the policy rate," RBI Governor D Subbarao said adding March end inflation would be 7 per cent.

RBI lowered growth projection for 2011-12 to 7 per cent from 7.6 per cent in view of global slowdown and domestic policy constraints. The new CRR rate would be 5.5 per cent.

The stock market reacted positively to the policy announcement and the banking stocks, in particular, shot up.

Subbarao warned that unless the government contains its fiscal deficit, rate cut is not possible. "In the absence of credible fiscal consolidation, the RBI will be constrained from lowering the policy rates...the forthcoming budget must begin this process in a credible and sustainable way".

Commenting on the RBI decision, Secretary in the Department of Economic Affairs, R Gopalan, said, "CRR cut ensures that fair amount of money is available, the cost of

fund is reduced ... All these things are good to create a growth enhancing impression."

Projecting a lower growth of 7 per cent for 2011-12, RBI said the policy actions are meant to "mitigate downside risks to growth" and anchor inflationary expectations.

Subbarao said, "Even as inflation remains elevated, despite moderation, downside risks to growth have increased.

The growth-inflation balance of the monetary policy stance has now shifted to growth".

He further said slippage on fiscal deficit, crude prices and rupee depreciation are key challenges for inflation, which after remaining near double digit for almost two-years came down to 7.5 per cent in December 2011.

The Reserve Bank also said the government should deregulate diesel prices in order to contain the trade deficit, which is expected to widen to USD 160 billion during the current fiscal.

The central bank further said the current levels of domestic prices of petroleum products do not reflect international prices.

The Chairman of Prime Minister's Economic Advisory Panel, C Rangarajan, said RBI has taken a "wise decision" and it would lead to softening of interest rate.

"Improvement in liquidity condition will automatically have effect on interest rate. Improvement in liquidity condition will lead to softening of interest rate," he said.

Reacting to the policy, while several bankers said that they may not go in for rate cut immediately, a few like Oriental Bank of Commerce Executive Director S C Sinha said the CRR cut would "definitely lead to reduction in interest rates."

The followings are the highlights of the third-quarter review of the Monetary Policy announced by Reserve Bank of India Governor D Subbarao:

* Cash reserve ratio lowered by 0.50 pc to 5.5 pc

* Short term lending rate (repo) retained at 8.5 pc

* Short-term borrowing rate unchanged at 7.5 pc

* CRR cut to infuse additional Rs 32,000 crore liquidity

* GDP growth estimate for 2011-12 cut to 7 pc from 7.6 pc

* Downside risks to growth have increased

* March-end inflation projection at 7 pc

* Upside risks to inflation remains

* Bank rate retained at 6 per cent

* Fiscal slippages threat to economic stability

* Investment, capital inflows have slowed down

* Fiscal deficit to overshoot Budget estimate

* Injected Rs 70,000 cr in November-January through OMOs

* Next review of monetary policy on March 15.

COMMENTARY:

SAILESH K. JHA, HEAD OF ASIA STRATEGY, SKANDINAVISKA ENSKILDA BANKEN, SINGAPORE

Very dovish statements. My takeaway is this is negative for INR as inflation will re-accelerate by February, growth will surprise high, and fiscal concerns are looming. We expect USD/INR to be close to a bottom.

I don't see a cut in the CRR to be a precursor to (a) change in the key benchmark rate in the March policy. We are hawkish on the outlook for inflation. There is a possibility of a CRR cut in the coming policy but I don't see a policy rate cut coming yet.

RADHIKA RAO, ECONOMIST, FORECAST, SINGAPORE

Cut in the CRR could be perceived as a precursor to change in the key benchmark rate, with odds for a 25 bps cut in March, earlier than we had anticipated.

Accompanying comments still see the central bank maintain a cautious tone on inflation, despite signs of softening growth and external headwinds, which highlights the tight bind the authorities are in.

Nonetheless, policymakers will draw confidence from the food-prices driven slowdown in inflation and lower rates in the coming months. We look for 75 bps cut by end-2012.

SAUGATA BHATTACHARYA, ECONOMIST, AXIS BANK, MUMBAI

The cut in cash reserve ratio is an excellent step that the Reserve Bank of India has taken in reversing its monetary policy stance, but it is not an indication that the next move would be a rate cut. They have very clearly specified that the rate cut would depend on the fiscal environment.

ARUN KEJRIWAL, STRATEGIST, KRIS, MUMBAI

I think it's a little bit of a gamble -- if this can provide a thrust to the economy which is slowing down, so be it. We are used to having unpleasant surprises, but this time, it's a pleasant surprise.

JAGANNADHAM THUNUGUNTLA, STRATEGIST AND HEAD OF RESEARCH, SMC GLOBAL SECURITIES, NEW DELHI

The CRR cut is more of an indicator that the repo rate and reverse repo rate cuts are around the corner and I believe that would happen in March. I think growth and inflation are equally important for the central bank now.

SHUBHADA RAO, CHIEF ECONOMIST, YES BANK, MUMBAI

If the fall in inflation trajectory going forward is in line with expectation, then the cut in CRR should be followed by a 50 basis points cut in the repo rate in March.

If monetary policy transmission has to be effective, then a 50 basis point cut is needed to stimulate investment demand.

SUMEDH DEORUKHKAR, SENIOR ECONOMIST, BBVA, MUMBAI

RBI has clearly said growth concerns have come center-stage despite lingering inflationary pressures.

So we expect the central bank to go for a 25 bps repo rate cut in (its) March review. Deeper rate cuts will be seen only after RBI sees clear signs of easing in the core inflation.

We expect repo rate cut worth 150 bps by end of December.

SUJAN HAJRA, CHIEF ECONOMIST, ANAND RATHI SECURITIES, MUMBAI

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.

We think that in the second half of next fiscal year, inflation will start going up again and hence the window for monetary easing is limited. We expect 75 to 100 basis point of rate cut by October, and at least another 50 basis point of CRR cut during the same period.

ANUBHUTI SAHAY, ECONOMIST, STANDARD CHARTERED BANK, MUMBAI

Their cautious stance is not surprising as imported inflation has emerged as a reason to worry. Going forward we expect inflation to be in the 6.5-7.0 per cent range by March and a repo rate cut in Q2 2012.

ASHUTOSH DATAR, ECONOMIST, IIFL, MUMBAI

Prima facie it looks like the central bank may go for further reduction in the cash reserve ratio if liquidity stays tight in coming months and so the sense of certainty on a rate cut in March has reduced.

That said, the RBI may continue with the aggressive pace of bond buybacks through open market operations if liquidity deficit stays above 1 trillion rupees despite today's CRR cut.

MARKETS:

The 10-year benchmark bond yield dropped 4 basis points to 8.08 per cent from beforehand.

The benchmark five-year swap rate fell 4 basis points to 7.20 per cent, while the one-year rate slid 7 bps to 7.86 per cent.

The main share index extended gains, while the rupee was little changed at 50.04/05 to the dollar.

BACKGROUND:

- India's growth outlook and business climate have weakened but upward risks to inflation remain, the Reserve Bank of India (RBI) said on Monday.

- The wholesale price index, the main inflation gauge, rose 7.47 per cent in December from a year earlier -- easing below 9 per cent annual pace for the first time in a year as food prices cooled. However, manufactured products inflation edged up in December.

- The food price index declined 0.42 per cent in the year to Jan. 7, compared with an annual drop of 2.9 per cent in the previous week. The fuel price index climbed an annual 14.45 per cent, the same as the week before.

- Production at factories, mines and utilities grew 5.9 per cent from a year earlier in November, the fastest clip since June, recovering from a contraction in the previous month and well above the forecast of 2.2 per cent growth in a Reuters poll.