"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 while unveiling the third quarterly monetary policy review.
With additional liquidity by CRR cut, there is a possibility that banks may reduce the interest rate to attract borrowers.
Projecting a lower growth of 7% for 2011-12, the Reserve Bank said the policy actions are meant to "mitigate downside risks to growth" and anchor inflationary expectations.
The CRR, the amount of deposits the banks are required to keep with RBI in cash, has been reduced to 5.5% from 6% with effect from January 28, releasing Rs 32,000 crore in the system to ease the liquidity problems. The short-term lending rate (repo) has been kept unchanged at 8.5%.
The policy said through the multiplier effect, additional credit to the tune of Rs 1.6 lakh crore would be generated in the system over a period of time.
The stock market reacted positively to the policy announcement and the banking stocks, in particular, shot up.
The RBI retained the repo or the short-term lending rate at 8.5% while making it clear that any cut in it will only happen after moderation in inflation.
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% in December 2011.The central bank expects the headline inflation to moderate to 7% by March, but there are concern over the persistently high prices of non-food manufacturing items.
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.
"The improvement in liquidity condition will automatically have effect on interest rate. Improvement in liquidity condition will lead to softening of interest rate," he said.
On CRR cut, RBI said, "Persistence of tight liquidity conditions could disrupt credit flow and further exacerbate growth risks...CRR is the most effective instrument for permanent liquidity injections..."
It indicated that future rate actions can see more lowering on the front.
Apart from easing liquidity pressures, the RBI said the policy actions are aimed at mitigating downside risks to growth and anchoring medium term inflation expectations.
Liquidity deficit has been consistently above the RBI's comfort level for the past three months, with banks' borrowing from the overnight borrowing going up to Rs 1.20 lakh crore this month.The Reserve Bank has been using its "first instrument of choice", the open market operations (OMO) to tide over the liquidity concerns, and has bought back Rs 70,000 crore worth of government securities from the market in the recent past.
Subbarao, however, said that growth will be faster next fiscal than the current one and the Reserve Bank will come out with a formal projection in its annual monetary policy statement on April 17.
A shift to growth marks a significant change in the thinking process at Mint Road as it had been working with a single point agenda of managing inflation for 18 months till the December mid-quarter review, when it hinted at taking a dovish stance.
The inflation-directed rate tightening saw 13 hikes and an effective increase of 3.75% in the lending rate.
Reacting to the policy, Oriental Bank of Commerce Executive Director S C Sinha said, "It is a welcome step. It will inject much needed liquidity in the system".
The RBI policy action definitely lead to reduction of interest rates. Softening of rates will take place in coming days, he said.
RBI said the fiscal deficit will "substantially" overshoot the budgeted level of 4.6% and will be "constrained" to not lower rates if the fiscal consolidation process is not carried out in earnest.
"The anticipated fiscal slippage, which is caused largely by high levels of consumption spending by the government, poses a significant threat to both inflation management and more broadly, to macroeconomic stability,” it said.
It said the Union Budget for 2012-13 must address these concerns in a "credible' and "sustainable" manner.
As an immediate measure, the RBI has suggested de-controlling of diesel prices along with keeping a tab on food subsidy, which will take care of both aggregate demand and trade deficit.