The Reserve Bank of India (RBI) on Tuesday cut the cash reserve ratio (CRR) by 50 basis points from 6 per cent to 5.5 per cent with effect from January 28, which would release Rs.32,000 crore into the financial system.

Signalling a shift in its policy, which the central bank followed in the last two years — fighting inflation — it now plans to revive growth by injecting liquidity into the system. However, persisting inflationary pressure persuaded the RBI from reducing the policy indicative rates.

The RBI kept the repo rate unchanged at 8.50 per cent for the second consecutive time after raising it 13 times between March 2010 and October 2011.

CRR is the percentage of deposits that commercial banks must keep with the central bank. Repo rate is the rate at which banks borrow from the central bank. The RBI's action is seen as an attempt to strike a balance between risks to growth and inflation. The declining growth is a worry for the RBI and its projection of GDP growth for this financial year is revised downwards from 7.6 per cent to 7 per cent.

“There is an urgent need for decisive fiscal consolidation, which will shift the balance of aggregate demand from public to private, and from consumption to capital formation. This is critical to yielding the space required for lowering rates without the imminent risk of resurgent inflation,” said D. Subbarao, RBI Governor, while addressing a press conference to announce the third quarter review of the Monetary Policy. “The forthcoming Union Budget must exploit the opportunity to begin this process in a credible and sustainable way,” Dr. Subbarao added.

The RBI Governor noted that the growth-inflation balance of the monetary policy stance had now shifted to growth, while at the same time ensured that inflationary pressures remained contained.

Further, Dr. Subbarao said the current inflation trajectory made it premature to cut the policy rate. According to him, “inflation remains high.” “Moreover”, he added, “there are upside risks to inflation from global crude oil prices, the lingering impact of rupee depreciation, and slippage in the fiscal deficit.”

However, Dr. Subbarao said, “liquidity conditions have remained tight beyond the comfort zone of the Reserve Bank.”

Although the RBI has conducted open market operations, and injected liquidity of over Rs.70,000 crore, the structural deficit in the system has increased significantly. This could hurt credit flow to productive sectors of the economy. “The large structural deficit in the system presented a strong case for injecting permanent primary liquidity into the system.”

Reserve Bank Of India: Third Quarter Review of Monetary Policy 2011-12 - Download PDF

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