The RBI surprised the market with a more-than-expected 50bps cut in the repo rate. The aggressive rate action, on the face of it, is puzzling as the recent communiqué from the monetary authority suggested that the risks to inflation were still strong and that inflation continues to be sticky at an uncomfortable level.

Thus, with March Headline WPI at 6.89 per cent, there were not many in the market who would have expected the RBI to deliver this decision. In effect, the central bank has front-loaded its monetary policy action, probably indicating that a 25 bps cut without a simultaneous reduction in CRR might not result in an effective monetary transmission. Further, there was probably a need for the RBI to nurture the saucer-shaped recovery that is now taking place.

The RBI's guidance for future monetary policy is for a status quo . This is because it feels that growth could revive to around 7.3 per cent in FY13 that is close to the current potential rate. Any attempt to push growth further via a bigger easing on the monetary side could be risky as it would lead to re-emergence of inflation pressures in the economy. It is now the turn of the fisc to deliver its bit on containment of aggregate demand.

In the days ahead, the RBI would remain cautious on the inflationary dynamics and would crucially track the second round implications of domestic oil price increases. A large second round impact would clearly indicate a continuation of pricing power of corporate, in turn pointing to strong demand dynamics. In effect, the RBI has probably taken up a big gamble with this aggressive rate movement, especially in an atmosphere where inflation dynamics continue to look problematic.

Implication for markets

There is unlikely to be much impact on the currency markets and the dynamics for the Indian rupee would continue to be largely dependent on risk appetite in global financial markets. The 10-year benchmark bond had already been pricing a monetary easing, but had priced in only a 25 bps of drop. However, further softening in the benchmark G-sec yield may not be warranted as the supply pressures continue to stay strong. The near term range for the 10-year benchmark bond thus appears to be at around 8.25-8.65 per cent.

More importantly, it is unclear how much of today's action could lead to drop in the corporate borrowing costs in the debt market. This is important as investment demand in the economy is unlikely to be re-kindled without such a reduction in such borrowing costs. Unfortunately, the borrowing programme of the Central government remains large.

(The author is President – Group Treasury and Global Markets, Kotak Mahindra Bank. The views are personal)

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