India unexpectedly slashed its benchmark interest rate by a greater-than-forecast half a percentage point, seeking to bolster growth with the first reduction since 2009. Inflation might limit the room for further cuts, the central bank said.

Governor Duvvuri Subbarao lowered the repurchase rate to 8 percent from 8.5 percent, the Reserve Bank of India said in a statement in Mumbai today. The outcome was predicted by three of 25 economists in a Bloomberg News survey. Seventeen expected a 0.25 percentage-point cut and the rest predicted no change.

Subbarao’s decision for a bigger move stoked gains in the rupee and government bonds as the step may strengthen growth in an economy hampered by political gridlock deterring investment and a European debt crisis hurting exports. Policy makers are seeking at the same time to avoid a reacceleration in inflation that remains the fastest among the biggest emerging economies.

“Slowing inflation along with growth moderation is nudging the RBI to ease policy,” said Indranil Pan, chief economist at Kotak Mahindra Bank Ltd. in Mumbai. “However, going forward, the aggressiveness of rate cuts would be missing due to risks to inflation” from high commodity prices, the rupee’s decline and loose fiscal policy, Pan said.

Bond Yields

The yield on the most-traded 8.79 percent notes due November 2021 fell to 8.36 percent as of 11:05 a.m. in Mumbai, from the day’s high of 8.51 percent and yesterday’s close of 8.46 percent, according to the Reserve Bank of India’s trading system. The rupee strengthened 0.3 percent to 51.52 per dollar, according to data compiled by Bloomberg.

“The reduction in the repo rate is based on an assessment of growth having slowed below its post-crisis trend rate which, in turn, is contributing to a moderation in core inflation,” the Reserve Bank said. “However, it must be emphasized that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates.”

Gross domestic product may expand 7.3 percent in the year through March 2013, compared with the baseline projection of 7 percent for the previous 12 months, the central bank estimated today. Inflation will probably be at 6.5 percent by the end of the current financial year, it said.

Risks to Outlook

Uncertainty about global commodity prices, particularly crude oil, India’s fiscal shortfall, a “very high” current- account deficit and food inflation are among risks to the outlook, the Reserve Bank said.

Growth has been hurt by declining investment and moderating consumer spending after the Reserve Bank raised rates by a record 3.75 percentage points from March 2010 to October last year to fight inflation.

Subbarao has already eased monetary conditions by reducing the amount of deposits lenders must set aside as reserves twice this year, by a combined 125 basis points, to 4.75 percent to ease cash shortages in the banking system. He left the cash reserve ratio unchanged today. Liquidity is “steadily moving towards” its comfort zone, the RBI said.

Recent patterns of inflation and expansion signal India’s trend rate of economic growth has declined from its peak before the financial crisis, the Reserve Bank said. Significant supply bottlenecks in infrastructure, energy, minerals and labor are among the main reasons why, it said.

Inflation Eases

The 6.89 climb in March in the benchmark wholesale-price index exceeded the median 6.65 percent estimate in a Bloomberg News survey of 33 economists, data showed yesterday. While Indian inflation has eased from more than 9 percent recorded in most of 2011, it remains the fastest in the so-called BRIC group of largest emerging economies that also includes Brazil, Russia and China.

Monetary policy will continue to aim to “condition and contain perception of inflation” in the range of 4 percent to 4.5 percent, the monetary authority said.

“The RBI is faced with a very difficult situation as growth is slowing and inflation remains high,” said Rupa Rege Nitsure, an economist at state-owned Bank of Baroda in Mumbai. India needs “efforts from the government’s side to boost the capacity of the economy by accelerating reforms,” Nitsure said.

Rising Costs

Higher raw material costs and the rupee’s decline are leading companies including steel makers to raise prices. Steel Authority of India Ltd., the nation’s second-largest producer, increased tariffs in April for the fourth time in three months.

Prime Minister Manmohan Singh’s government, grappling with fiscal and trade gaps and depressed industrial output, faces one of the most challenging periods since taking office in 2004.

In the budget on March 16, the administration announced record borrowing needs to plug a fiscal shortfall estimated at 5.1 percent of gross domestic product in 2012-2013. The current- account deficit reached $19.6 billion in the three months through December, the worst quarterly performance on record.

“From the perspective of vulnerabilities emerging from the fiscal and current account deficits, it is imperative for macroeconomic stability that administered prices of petroleum products are increased to reflect their true cost of production,” the Reserve Bank said.

A current-account gap at 4.3 percent of gross domestic product in the fourth quarter of 2011 is unsustainable, it said.

Policy reversals have further hindered Singh’s economic agenda, including the suspension of plans in December to open India’s retail industry to foreign companies.

Bloomberg