The rupee fell and bond yields surged after the central bank surprised markets with a hike in the repo rate on Friday, putting its focus squarely back on managing inflation and the fiscal deficit.
However, the central bank also unwound some of the cash tightening steps undertaken since mid-July, lowering the marginal standing facility rate by 75 basis points to 9.5 percent and the minimum daily average cash balance that banks need to maintain to 95 percent from 99 percent previously.
The central bank's move to raise the short-term rates had roiled bond markets and raised corporate borrowing costs.
"It is an honourable exit for the RBI and is the best way Rajan could take a step back towards normalising things. The hike in repo rate gives the message that inflation is still high but he is trying to bring down the MSF corridor," said Manish Wadhawan, head of interest rate trading at HSBC in Mumbai.
"The bond yield curve and the OIS curve is steepening and it will steepen more until the central bank's next policy review in end-November."
However, the market chose to focus on the surprise rate hike and the central bank's assessment that inflation could be higher than what was initially projected.
"It is a very mixed policy, we have a rate cut and a rate hike in the same document. While we do expect yields to settle down over a period of time, it will be at a higher level. Net net, the market is treating it as a rate hike rather than a rate cut," said R. Sivakumar, head of fixed income at Axis Mutual Fund in Mumbai.
The rupee extended losses after the decision, falling as much as 62.55 to a dollar from 61.93/61.99 previously. It closed at 61.77/78 on Thursday.
It had fallen as much as 20 percent to record lows in late August, but had recovered more than 9 percent since Rajan took office on Sept 4 through Thursday.
Bond yields rose, with the 10-year bond yield rising to the day's high of 8.45 percent, up 26 bps on the day.
The Nifty extended losses to nearly 3 percent, with banking stocks leading declines. The main banking index was down over 6 percent.