15/01/2015 10:33 AM IST | Updated 15/07/2016 8:24 AM IST

Markets On A High After RBI Rate Cut

Bloomberg via Getty Images
Raghuram Rajan, governor of the Reserve Bank of India (RBI), reacts during a news conference at the central bank's headquarters in Mumbai, India, on Tuesday, Dec. 2, 2014. Rajan left interest rates unchanged for a fifth straight meeting while signaling a possible easing early next year after Prime Minister Narendra Modis government called for lower borrowing costs. Photographer: Dhiraj Singh/Bloomberg via Getty Images

Reserve Bank of India Governor Raghuram Rajan cut interest rates in an unscheduled review today. The stock market surged in response.

Rajan cut the benchmark repurchase (repo) rate to 7.75 percent from 8 percent. This is the first reduction since May 2013, when inflation was on the rise. That situation has changed, and the RBI expects consumer price inflation will remain below the bank's target of 6 percent.

Markets surged on the announcement. The BSE Sensex rose 2.3 percent, its highest spike in last eight months. The rupee rose to 61.72 per dollar compared with its previous close of 62.18, its strongest showing in the last two months. Yield on India's sovereign 10-year bond dropped 10 basis points to 7.67 percent, the lowest level since July 2013. A lower yield indicates less risk and is more attractive for global investors.

Finance Minister Arun Jaitley said this was a positive step. "This will put more money in the hands of consumers," he said in a television interview.

"The Governor had said that he doesn’t want to cut rates and then reverse it later. So this rate cut is consistent with strong disinflationary pressures," said chief economic adviser Arvind Subramanian on CNBC-TV18. "This does signal a shift in the underlying stance going forward."

The rate cut's timing was unexpected because the next scheduled review is on February 3. Rajan had earlier hinted at a possible rate cut in the previous review on December 2, 2014 after inflation continued to slow.

There was growing demand for a rate cut from Jaitley, but Rajan had preferred to wait to see if the risk of inflation had gone down before deciding on a cut. Falling global commodity prices and low consumer inflation in India might have led Rajan to decide that inflation has reached a level from where it is unlikely to rise above RBI's target. More cuts might follow after the budget if inflation stays low.

"Key to further easing are data that confirm continuing disinflationary pressures. Also critical would be sustained high quality fiscal consolidation as well as steps to overcome supply constraints and assure availability of key inputs such as power, land, minerals and infrastructure," said Rajan in a statement on the rate cut.

A repo cut makes lending easier as banks usually pass it on to consumers. Their higher spending helps the economy grow. This is good news for both businesses and Jaitley, who is expected to go for bolder reforms after a lacklustre budget last year.

“The next big trigger that the market will eye is the Budget. Investors want bold reforms from the government,” said Motilal Oswal, chairman of Motilal Oswal Financial Services.