"While the series of policy initiatives by the Government has boosted market sentiment, it will take some time to reverse the investment slowdown and reinvigorate growth. Accordingly, the baseline projection of GDP growth for 2012-13 is revised down from 5.8 per cent to 5.5 per cent," RBI said in its third quarter monetary policy review.
The growth estimate of 5.5 per cent is lower than 5.7 per cent projection by the government, which would be the lowest growth recorded in a decade.
It had in October lowered the GDP forecast for the current fiscal to 5.8 per cent, from 6.5 per cent in July.
"The key to stimulating growth is a vigorous and sustained revival in investment," RBI said, adding that achieving this would require bridging the infrastructure gap, fast tracking project clearances and improving governance.
The RBI today lowered key policy rates and Cash Reserve Ratio (CRR) by 0.25 per cent, thereby releasing additional liquidity of Rs 18,000 crore into the system.
"It is critical now to arrest the loss of growth momentum without endangering external stability," it said.
The government has recently taken a host of reform initiatives, including liberalisation of FDI in some sectors like multi-brand retail, amending the Banking Regulations Act and partial deregulation of diesel prices.
Further, the RBI also lowered the March-end inflation projection to 6.8 per cent, from 7.5 per cent estimated earlier.
It, however, expected that inflation would remain range bound around current levels due to persistent food inflation and pass through of diesel price adjustments.
"This provides space, albeit limited, for monetary policy to give greater emphasis to growth risks," the RBI said.
December WPI inflation fell to 7.18 per cent, but was higher than the RBI's comfort level of 5-6 per cent.
"The moderation in inflation conditions provides the opportunity for monetary policy to act in conjunction with fiscal and other measures to stem growth risks," Subbarao said.
He praised government's recent reform measures including liberalisation of Foreign Direct Investment (FDI) in retail, deferment of General Anti Avoidance Rules (GAAR) and progressive deregulation of fuel prices saying these actions would "help engender stable macroeconomic conditions and return the economy to its high growth trajectory."
Stock market celebrated the rate cut with a 91 point rally in early trade to take the benchmark Sensex to 20,194.06
Planning Commission Deputy Chairman Montek Singh Ahluwalia said the CRR cut will have impact on long term interest rates.
"I think this is the right thing to do at this point of time given that (the decline) in economy is beginning to bottom out," he said.
On the possible impact of the RBI's decision on the interest rates, Bank of India executive director N Seshadari said most of the banks will transfer the rate cut. "Full transmission will happen on both lending and deposit rates. A 0.25 per cent cut is most likely."
Echoing similar views, Canara Bank executive director A K Gupta said the bank would consider interest rate cut in the light of RBI policy action.
The repo rate, which was cut last in April 2012, stands revised at 7.75 per cent with immediate effect, while the liquidity infusing CRR stands at 4 per cent effective February 9.
On Monday, the RBI had left everyone guessing with a hawkish policy stance in the third quarter macroeconomic and monetary development report stating that sticky inflation and widening fiscal and current account deficits limited its scope for a rate cut.