The Reserve Bank of India surprised markets with a 25 basis point cut in interest rates on Thursday and signalled it could do more, amid signs of slowing inflation and what it said was a government commitment to contain the fiscal deficit.

While the early move was unexpected, aggressive reductions in rates have been expected over the course of the year to help India's economy out of a rut, with growth rates struggling to recover from their weakest levels since the 1980s.

Acting ahead of a scheduled RBI policy meeting on February 3 and the government's annual budget statement late next month, the central bank lowered the repo rate - its key lending rate - to 7.75 per cent from 8.0 per cent, where it had been for the past year.

As a result the reverse repo rate, the rate at which the central bank drains excess liquidity from the banking system, also moved down by 25 basis points to 6.75 per cent.

The cut was seen as a concession by RBI Governor Raghuram Rajan to the government of Prime Minister Narendra Modi as it pursues policies to encourage investment-led growth, while seeking fiscal consolidation.

"The cut was expected in first quarter, but has come sooner than expected and frontrun the February budget," said Radhika Rao, economist at DBS Bank.

"This demonstrates RBI's confidence in the evolving inflation outlook and it shows that they are putting faith in government's fiscal consolidation plan."

Deputy Finance Minister Jayant Sinha said the cut marked an "inflection point" after a period of high interest rates.

SUBSIDING INFLATION PRESSURES

Largely thanks to plunging global oil prices and lower food costs, India has seen growing signs of a sustained slowdown in inflation.

Wholesale prices rose just 0.11 percent year-on-year in December, after staying flat in November, according to data released on Wednesday. A Reuters poll of economists had forecast a 0.6 per cent rise.

Retail inflation, meanwhile, rose to 5 per cent in December -- again below the 5.4 per cent annual rise predicted by a Reuters poll. The RBI has targeted retail inflation at 6.0 per cent by January next year.

The RBI cited lower-than-expected inflation, weak crude prices and flagging demand as the reasons for its move, as well as the government's commitment to sticking to a fiscal deficit target. It said further moves would take the same factors into account.

"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," the central bank said in a statement.

Some analysts suggested Rajan may have come under pressure from the government to lower interest rates sooner than he would have ideally chosen.

"This is a surprise move in the middle of the war on inflation," said N R Bhanumurthy, a New Delhi-based economist at the National Institute of Public Finance and Policy.

"I am very surprised because it goes against the whole current governor's philosophy that monetary policy should be predictable. It shows the governor is very pragmatic and can look at his own position and can change."

MARKETS GAIN

India's stock market was the second best performer in Asia last year in dollar terms due to investors' hopes that Modi, who was elected in May, will push key reforms and invest in infrastructure to unlock India's growth potential, having suffered two consecutive years of sub-5 per cent growth.

The rate cut pushed the benchmark 10-year bond yield to 7.65 per cent, down 12 basis points on the day and its lowest level since July 15, 2013, while stocks rallied, with the NSE index gaining more than 2 per cent in early trade.

In the overnight indexed swap market, the one-year rate dropped as much as 13 bps to 7.50 per cent, its lowest since July 15, 2013, which traders said priced in an additional 100 bps in rate cuts. - Reuters