Weighed down by a weak rupee, the Reserve Bank chose to keep all key interest rates unchanged and asked the government to take urgent steps to reign in the high current account deficit.
Lowering the GDP growth projection for the current fiscal to 5.5 per cent from 5.7 per cent, the central bank said the external sector is the "biggest threat" to economic stability.
It also said that the recent liquidity tightening measures, taken to support the rupee, will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling it to revert to the policy of supporting growth with continuing vigil on inflation.
The RBI will endeavour to keep inflation, which is under threat from a depreciating rupee, at 5 per cent by March end.
"The policy stance is guided by the need for continuous vigil and preparedness to pro-actively respond to risks to the economy from external developments, especially those stemming from global financial markets," Governor D Subbarao said in what would be his last policy announcement unveiled in Mumbai.
Accordingly, the repo rate or the rate at which RBI lends to the system, has been retained at 7.25 per cent and the cash reserve ratio, the amount of deposits banks park with RBI, has been kept unchanged at 4 per cent.
Giving the policy guidance, the governor said "monetary policy going forward will be shaped by the consideration of supporting growth, anchoring inflation expectations and maintaining external sector stability." mid-quarter review on September 18, said the policy stance is aimed at addressing risks to macroeconomic stability and growth and guard against the re-emergence of inflationary pressure.
It would also endeavour to manage liquidity conditions to ensure adequate credit flow to productive sectors of the economy.
The current situation of low headline inflation, prospects of softening food inflation on a good monsoon and decelerating growth warranted a pro-growth policy stance, but for the difficulties on the external front, as reflected in the almost 10 per cent depreciation in the rupee and the rising current account deficit, he said.
Stating that the external sector was the "biggest risk to macroeconomic stability," Subbarao called for urgent policy steps from the government to curtail the CAD to a sustainable level of 2.5 per cent of GDP and said that the RBI is ready to use all instruments under its command help in the efforts.
"It should be emphasised that the time available now should be used with alacrity to institute structural measures to bring CAD down to sustainable levels," the Governor said.
The recent liquidity tightening measures, brought in to reduce speculative pressures on the rupee, which had hit a record low of 61.21 to the dollar on July 8, will be rolled back once the currency stabilises, which will lead to a shift in the monetary policy to be more accommodative and pro-growth, he added.
The benchmark S&P BSE Sensex opened higher and remained flat soon after the unveiling of the policy, which was along expected lines.