The RBI, in its Third Quarter Review of Monetary Policy, increased the short-term lending (repo) rate to 8 per cent from 7.75 per cent and indicated a pause in terms of further rate hikes.
The central bank lowered its growth forecast for the current financial year to less than 5 per cent from 5.5 per cent and said inflation will continue to hover around 8 per cent in the next fiscal.
"...an increase in the policy (repo) rate by 25 basis points is needed to set the economy securely on the recommended disinflationary path," Rajan said.
Consequently, the reverse repo rate under the liquidity adjustment facility will be revised to 7 per cent and the marginal standing facility rate and bank rate to 9 per cent.
However, the RBI kept the cash reserve ratio unchanged at 4 per cent as liquidity seems to be comfortable.
It was widely expected that Rajan would maintain the status quo on rates to support growth. Ahead of the quarterly review, Rajan had termed inflation a "destructive disease."
While industry expressed its "disappointment," bankers said they will take a view on raising interest rates, depending on demand for credit and other factors.
The asset liability committee of the country's largest lender State Bank of India will review interest rates shortly.
"While the Governor has given a repo rate increase, he has clearly said that this could be end of the tightening cycle," SBI Chairperson Arundhati Bhattacharya said.
"As of now it (interest rate hike) looks unlikely, but we need to look at the overall data and then take a decision," SBI Managing Director A Krishna Kumar said.
Commenting on the policy, Ficci said, "Rise in repo rate has disappointed industry...We also hope the banks will not hike the lending rates as this would scuttle revival."
The policy rate has been increased thrice, by 0.25 per cent each, since Rajan took over as Governor in September.
Defending the policy stance, Rajan said a rate cut would not have affected banks or borrowers and that bringing down retail prices is the key to sustainable growth.
"If we cut policy rates, it won't have any impact on banks' cost of funds or lending rates for borrowers," Rajan told reporters at the customary post-policy press conference.
Retail inflation, at 9.87 per cent last month, is expected to be above 9 per cent in the fourth quarter and 7.5-8.5 per cent in Q4 of the next financial year, the RBI said.
"Consumer price inflation is too high, we need to bring it down...and we should be able to reach the 8 per cent objective by end of the year with this rate hike," he added.
The RBI's baseline projections for retail inflation indicate that over the ensuing 12-month horizon, and with the current policy stance, there are upside risks to the central forecast of 8 per cent.
"The extent and direction of further policy steps will be data dependent, though if the disinflationary process evolves according to this baseline projection, further policy tightening in the near term is not anticipated at this juncture," he said.
The Governor said economic growth would be below 5 per cent in the current financial year and could accelerate in 2014-15 to a mean projection of 5.5 per cent.
Rajan said growth is likely to lose momentum in the third quarter of 2013-14. Economic expansion in the first half of 2013-14 was 4.6 per cent. In order to record a 5 per cent in the full year, second-half growth should be 5.4 per cent.
On the external sector, Rajan said a silver lining is the significant narrowing of the trade deficit on the back of resilient export growth.
"The current account deficit for 2013-14 is expected to be below 2.5 per cent of GDP compared with 4.8 per cent in 2012-13," he said.
Stocks fell sharply after the policy announcement and remained volatile through the day. The benchmark Sensex closed at 20,683.51, down 0.12 per cent.