For RBI, inflation outweighs growth

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So, RBI was clearly in a dilemma at Monday's policy review, where they left the key rates unchanged at a time when a rate cut could have acted as a stimulus. "While growth in FY 2011-12 has moderated significantly, headline inflation remains above levels consistent with sustainable growth," said the RBI policy in defence of the rate inaction. "Importantly, retail inflation is also on an uptrend."

Last time round, according to the minutes of meeting of the Technical Advisory Committee on Monetary Policy, on April 11, the six member committee had divergent views on monetary policy and liquidity measures. Of the six external members who attended the meeting, four suggested that RBI should continue to pause. They felt that unless supply side constraints were addressed and relevant measures were taken to revive investment activity, the reduction in the policy rate would not have any impact.

FROM THE MAGAZINE: Govt inaction behind poor growth indicators

In Monday's policy review, RBI referred to having frontloaded the policy rate reduction in April with a cut of 50 basis points. "This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives," said RBI in the policy review. RBI's assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small.

"Consequently, further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures."

FROM THE MAGAZINE: Govt inaction behind poor growth indicators

And this time, RBI has more in defence of its decision to keep interest rates unchanged. According to RBI, estimates suggest that real effective bank lending interest rates, though positive, remain comparatively lower than the levels seen during the high growth phase of 2003-08. "This suggests that factors other than interest rates are contributing more significantly to the growth slowdown," according to the policy.

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In its guidance, RBI has highlighted that the evolving growth-inflation dynamic will continue to influence its stance on interest rates. Core inflation has moderated, reflecting demand conditions and lower pricing power. However, both headline and retail inflation rates are rising, which have a bearing on inflation expectations. "Future actions will depend on a continuing assessment of external and domestic developments that contribute to lowering inflation risks," said the central bank.

PERSPECTIVE: Has RBI left growth to fend for itself?