MUMBAI (Reuters) - With elections looming and an uncertain economic growth outlook, the Reserve Bank of India (RBI) left interest rates on hold on Tuesday, as expected, and indicated it will keep rates steady in the near term if inflation eases towards the bank's targeted level.
But in a move to impose more discipline on lenders and in line with global practice, the central bank cut the amount of overnight funding it makes available to banks, nudging them to use longer-term funding in a push to deepen financial markets.
The RBI kept its key repo rate at 8.00 percent, in line with the forecast of all 53 economists in a Reuters poll last week, although RBI Governor Raghuram Rajan warned of risks that inflation could rise even as risks to economic growth are to the downside.
Since taking office in September, Rajan has raised the repo rate three times by a total of 75 basis points, but with India headed for elections starting next week and uncertainty over monsoon rains due to begin in June, all 53 economists in a Reuters poll had forecast Rajan would leave rates unchanged at its April meeting.
"RBI moves ahead will depend heavily on how closely the next government follows the fiscal consolidation path. The full budget for FY15 is therefore most important insofar as the election is concerned for the RBI," said Nizam Idris, a strategist with Macquarie Capital in Singapore.
India's consumer price index inflation eased to 8.10 percent in February - a 25-month low that brings it near the RBI's January 2015 target of 8 percent, while the wholesale price index slowed to a 9-month low of 4.68 percent.
Whichever party wins the most seats in elections due to finish next month, it will need the support of coalition partners to form the government, creating policy uncertainty.
"If electoral outcomes fail to provide a stable government, the downside risks to growth could accentuate," the RBI said in a report accompanying its policy statement.
Food prices, which depend on monsoon rains, have eased in recent months but have been a key inflation driver in the past few years. The RBI wants CPI inflation to ease further to 6 percent by January 2016.
"The Reserve Bank's policy stance will be firmly focused on keeping the economy on a disinflationary glide path," Rajan said, even as he reiterated his concern about stubbornly elevated core inflation.
"If inflation continues along the intended glide path, further policy tightening in the near term is not anticipated at this juncture," he said.
Rajan also cited risks to growth in an economy that probably expanded by less than 5 percent in the just-completed fiscal year, the slowest in a decade, noting that early signs do not yet indicate a sustained revival for industry and services.
He said there is downside risk to the 5 to 6 percent GDP growth estimate for the fiscal year that began this month.
Indian manufacturing activity grew at a slower pace in March as weaker domestic demand weighed on output growth, the HSBC Manufacturing Purchasing Managers' Index (PMI) showed on Tuesday.
Rajan, a high-profile former chief economist at the International Monetary Fund, has pushed financial market reforms in order reduce volatility and increase depth and transparency.
While the move to reduce availability of overnight funds to banks could spur near-term volatility in daily interbank lending and borrowing rates, it hastens the process of banks becoming more responsive to monetary policy action.
Rajan relaunched the long-dormant term repo market when he took office by gradually cutting back what had been unlimited overnight funds from the central bank, forcing banks to move towards market-determined rates.
"It will ... improve monetary policy transmission as banks will price their products more closely to the term market and react faster to any monetary policy action," said N.S. Venkatesh, treasurer at IDBI Bank.
Indian stocks were little changed after the monetary policy decision, while the local bond and foreign exchange markets were closed on Tuesday.
Additional reporting by Swati Bhat and Neha Dasgupta; Editing by Kim Coghill