Contrary to the expectations of the industry and experts, Rajan in his maiden policy opted for a hawkish monetary policy stance ahead of the festive season instead of shifting the focus to promotion of growth by lowering interest rates to generate demand.
The RBI Governor, however, eased liquidity through a reduction in the marginal standing facility rate, at which banks borrow from the central bank, by 0.75 percent to 9.5 percent and eased the minimum daily maintenance of the cash reserve ratio (CRR).
The repo rate, or the short-term lending rate, has been increased by 25 basis points to 7.5 percent from 7.25 percent with immediate effect. Other policy rates will be adjusted accordingly.
"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 policy statement."There will not be much impact on the interest rate immediately," Canara Bank Executive Director A K Gupta said when asked about the effect of the policy on home, auto and corporate loans.
The RBI, he added, "has done a balancing act. Much of the borrowing by banks is from the MSF window and the reduction of 0.75 percent will lower the cost of funds."
Wholesale price inflation rose to a six-month high of 6.1 percent in August, driven by costlier food items.
Rajan said WPI inflation will be higher than initially projected over the rest of the year in the absence of an appropriate policy response.
"What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence," he said.
"Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency," he added.
Stating that economic growth has weakened with continuing sluggishness in industrial activity and services, the RBI said the pace of infrastructure project completion is subdued and the start of new projects remains muted.
Although bankers don't see any immediate increase in interest rates for individuals and corporate borrowers, the benchmark S&P BSE Sensex tanked by as much as 595 points after the policy announcement, while the rupee depreciated 69 paise to 62.46 against the dollar.
"The increase in repo rate could have been avoided as industry is already reeling under pressures of high cost of capital and low availability in a tight liquidity situation...The increase in repo rate come as a surprise," CII Director General Chandrajit Banerjee said.
Yesterday, the country's largest lender, State Bank of India, increased its minimum lending rate to 9.8 percent.
Rajan left the CRR, or the portion of deposits that banks need to keep with the RBI in cash, unchanged at 4 percent.
At the same time, the RBI reduced the minimum daily maintenance of CRR from 99 percent of the requirement to 95 percent, effective from September 21, a move aimed at inducing liquidity into the system.
Observing that growth is trailing below potential and the output gap is widening, Rajan said, "Some pick-up is expected on account of the brightening prospects for agriculture due to kharif output and the upturn in exports."
He said concerns on the current account deficit have been mitigated with measures taken by the government and the RBI.
Also, steps have been taken to improve the environment for external financing, turning the focus to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation, he added.
Rajan said the timing and direction of further actions on exceptional measures will be contingent upon exchange market stability and can be two-way.
"Further actions need not be announced only on policy dates. However, any further change in the minimum daily maintenance of the CRR is not contemplated," he added.
Rajan, who rescheduled the policy review keeping in mind the two-day US Federal Reserve meeting, said activity has slowed in several emerging economies, buffeted by heightened financial market turbulence on the prospect of tapering of quantitative easing in the US.
"The decision by the US Federal Reserve to hold off tapering has buoyed financial markets but tapering is inevitable," he added.