The Reserve Bank of India in its first monetary policy review under the governorship of 'rockstar economist' Raghuram Rajan has increased repo rate (the rate at which the RBI lends money to banks) by 25 bps (0.25%) to 7.5%.
Economists had widely expected the RBI to leave the repo rate unchanged.
Rajan's hawkish move to raise lending rates was triggered by the observation that inflation is set to be higher than initially projected.
"The need to anchor inflation and inflation expectations has to be set against the fragile state of the industrial sector and urban demand. Keeping all this in view, bringing down inflation to more tolerable levels warrants raising the repo rate by 25 basis points immediately," Rajan said in the mid-quarter policy review statement.
"The governor is clearly worried about inflation," said Anjali Verma, chief economist at PhillipCapital in Mumbai.
"He is saying the improved international conditions will take care of the current account deficit funding and his focus will shift to the fiscal deficit and inflation, which were taking a backseat," she said.
The RBI also announced a lowering of marginal standing facility (MSF) rate by 75 bps (0.75%) to 9.50%. The RBI had lifted the MSF to 10.25 percent in mid-July to stabilise a declining rupee.
Rajan said on Friday that domestic drivers of the rupee now take precedence.
"The focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation," he said.
The Central Bank relaxed banks' minimum daily cash reserve requirement too - to 95% of deposits from 99% from September 21.
The CRR (Cash Reserve Ratio) which banks have to keep has been left unchanged at 4%.
From our archives: India, Raghuram Rajan and the Great Man Fallacy
At 11:05 am, the rupee was quoting at Rs 62.14 compared with previous close of Rs 61.77 per dollar.
The yield on the 10-year benchmark government bond 7.16% due May 2023 was at 8.35% compared with its previous close of 8.19%.
The markets first reaction has been a big thumbs down. At 1120 AM IST, the Sensex was down by 513 points.
Immediate Impact: Banks are likely to raise lending rates following the RBI's decision to raise the repo rate.
ANJALI VERMA, CHIEF ECONOMIST, PHILLIPCAPITAL, MUMBAI
"Hiking the repo rate was unexpected. The governor is clearly worried about inflation. He is saying the improved international conditions will take care of the current account deficit funding and his focus will shift to fiscal deficit and inflation, which were taking a backseat."
UPASNA BHARDWAJ, ECONOMIST, ING VYSYA BANK, MUMBAI
"While partial rollbacks of the exceptional measures were expected, RBI clearly has highlighted the need to anchor inflationary expectations by raising the repo rate. We expect inflationary concerns to continue to remain the dominant factor driving the trajectory for repo rate going ahead."
RUPA REGE NITSURE, CHIEF ECONOMIST, BANK OF BARODA, MUMBAI
"RBI has done excellent calibration today to bring India on par with other emerging market economies which have already raised policy rates. It is a clear and transparent signal. Also by easing short-term rates and liquidity, it has reduced the stresses on the shorter-end of the yield curve. It should be noted that this easing is partial so as to avoid a possible speculative response."
R SIVAKUMAR, HEAD OF FIXED INCOME, AXIS MUTUAL FUND, MUMBAI
"It is a very mixed policy, we have a rate cut and a rate hike in the same document. From a medium-term perspective, we see LAF rate becoming the operative rate that is clear, however the LAF rate itself will be higher than it cost before. While we do expect yields to settle down over a period of time, it will be at a higher level. Net net, the market is treating it as a rate hike rather than a rate cut.
"What's clear from a policy-making perspective is that the shift from WPI (wholesale price index) to CPI (consumer price index) will happen. And a very low core WPI inflation is not going to help bring rates down given that CPI is at 9.5 percent."