The Sensex fell 1 percent on Monday, led by a sell-off in lenders, after the Reserve Bank of India surprised markets by keeping both the repo rate and the cash reserve ratio unchanged.
Local shares had rallied in June, hitting a six-week high early on Monday's session, on expectations the RBI would ease policy after recent data showed economic growth in January-March fell to a nine-year low.
Instead, the RBI said it remains concerned about inflation, though the central bank did state it would monitor liquidity conditions, such as by purchasing bonds via open market operations as warranted.
The RBI is still expected to cut interest rates further after last easing the repo rate by 50 basis points to its current 8 percent in April, but the timing is now up in the air.
The focus now also shifts to the government, whose perceived lack of policy reform was a key factor behind the slump in local markets that sent the rupee currency tumbling to a record low in May.
"Rates are headed lower, but cuts are going to be more unpredictable," said Sandeep J. Shah, CEO of investment advisory firm S a mpriti Capital.
More From This Section
"Expectations from the government are at zero, and any significant action would therefore result in short-covering"
The Sensex fell 1 percent, after erasing earlier gains of as much as 0.9 percent that had brought the index to its highest since May 4.
The Nifty fell 1.1 percent.
Domestic stocks had rallied 4.5 percent this month as of Friday's close, after weak GDP data on May 31 had sparked expectations the RBI would cut rates.
Besides keeping interest rates unchanged, the RBI also disappointed investors by leaving the cash reserve ratio at 4.75 percent after last cutting the amount of money that lenders must keep with the central bank in March.
The surprise outcome sent the NSE banking index tumbling down 2.5 percent after the sub-index had gained 6.6 percent this month as of Friday's close.
State Bank of India dropped 3.3 percent, while ICICI Bank and HDFC Bank fell over 2 percent each.
Other rate-sensitive stocks also slumped, with property firm DLF down 4 percent and Unitech down 3.7 percent.
(Reporting by Abhishek Vishnoi and Manoj Dharra; Editing by Rafael Nam)