MUMBAI (Reuters) - The Reserve Bank of India unexpectedly lowered its policy rate for the second time this year on Wednesday, backing a government that is pushing to revive economic growth as inflation cools.
Although markets had broadly expected the RBI to reduce rates again after a cut in January, few had expected a move just days after the government unveiled a budget that took a slower path to lowering the fiscal deficit.
After cutting the policy repo rate by 25 basis points to 7.50 percent, RBI Governor Raghuram Rajan issued a statement citing his reasons for making the move a month before a scheduled policy review.
"Given low capacity utilisation and still-weak indicators of production and credit off-take, it is appropriate for the Reserve Bank to be pre-emptive in its policy action," he said.
The RBI embarked on an easing cycle on Jan. 15 with a quarter percentage point reduction that had also caught market off guard by taking place outside of a scheduled review.
The benefits have still to pass through to borrowers, however, as commercial banks have been hesitant about lowering their lending rates.
While seeing improvement in the economy, Rajan doubted whether it was doing as well as official gross domestic product data suggested, after recent changes to methodology showed India outpacing China by growing 7.5 percent in the last quarter.
"Nevertheless," he said, "the picture of a steadily recovering economy appears right."
Analysts said the latest rate reduction showed the RBI's trust in the 10-month-old government of Prime Minister Narendra Modi to maintain fiscal discipline even though it will take longer to reach its deficit goals.
The budget laid out plans to reduce the fiscal deficit to 3.9 percent of gross domestic product, in the 2015/16 financial year, and bring it down to 3.0 percent by 2017/18 - a year later than an earlier road map had targeted.
"This is a good beginning and we are going to be watchful," Rajan told analysts in a conference call. "There are lots of plans and a lot of intent (in the budget), so we are going to see how it rolls out."
Describing the deficit reduction plan as "very prudent", Minister of State for Finance Jayant Sinha said the government was striking a balance between making more gradual reductions in the deficit and investing in infrastructure and key sectors.
"It's that balance that the RBI has appreciated," Sinha said, responding to the interest rate cut.
The boost for the government also comes a week after it endorsed an RBI-led change to monetary policy, formally adopting inflation targeting. India is expected to establish a monetary policy committee, which could give the government more influence over decisions like interest rate moves, but its size and composition remain a matter of heated debate on both sides.
Indian bonds rose sharply after the cut. The benchmark 10-year bond yield dropped to as much as 7.61 percent, its lowest level since July 2013.
Yet while Rajan signalled he was optimistic inflation would remain contained and analysts said they continued to expect further monetary easing, most cautioned that the prospect of deep, fast cuts was now reduced.
"We expect one more rate cut (this year) but it looks as though the bias is towards more easing," said Frederic Neumann, Co-Head Of Asian Economics at HSBC in Singapore.
Indian inflation has moderated sharply as global oil prices have slumped since last year. In January, consumer prices rose an annual 5.11 percent, having fallen from double digit levels posted as recently as November 2013.
That puts inflation well within a target of 4 percent, with a band of plus or minus 2 percentage points, agreed by the RBI and the government, for the financial year beginning in April 2016.
Rajan, at the conference call with analysts, said the RBI would target an inflation rate of 4 percent by the end of January 2018, and said a real interest rate of 1.5 to 2.0 percent was appropriate at this point in the economic cycle.
India's rate cut comes as a slew of central banks across developed and emerging economies cut interest rates, including in Indonesia and China, despite the prospect of rising U.S. interest rates later this year.
Rajan's statement noted that the rupee's relative strength added to disinflationary pressures, but again warned that global events could reverse the trend.
Additional reporting by Suvashree Dey Choudhury, Swati Bhat, Sumeet Chatterjee, and Abhishek Vishnoi; Editing by Clara Ferreira Marques and Simon Cameron-Moore