Reserve Bank of India?s credit policy is due later this month. The latest data for industrial production and prices released in July will make RBI?s policy dilemma worse. Industrial production declined in May while core inflation rose sharply.

No simple prescription for monetary policy is applicable in such a situation. For understanding the latest trends in production and prices, we look at the seasonally adjusted data available from NIPFP at http://www.mayin.org/cycle.in/tracking.html. The industrial production data shows that the upswing seen since June 2009 is no longer visible. Figure 1 shows month-on-month IIP growth for seasonally adjusted data. The last data point in the figure shows data for May 2010, which witnessed a decline in the seasonally adjusted level of industrial production.

This scenario is not consistent with the view that industrial production in India is running at full capacity and that there is a need to tighten monetary and fiscal policies to prevent overheating and inflation. The graph for IIP manufacturing (Figure 2) shows the same thing i.e., the seasonally adjusted industrial production actually saw a decline in May 2010.

While month-on-month growth saw a decline in seasonally adjusted industrial production, this problem does not show up yet in the annual year-on-year inflation numbers (also seen in Figure 3 and 4). The year-on-year numbers show a small decline in the growth rate and will be able to capture the decline with a five and a half month lag. The difficulty for policymakers of declining growth is thus not an open concern as media discussions in India focus more on year-on-year growth rates. It would be critical to watch the seasonally adjusted month-on-month numbers for formulation of policy in the coming months. Shrinking output, if accompanied by a contraction in demand owing to fiscal and monetary tightening, can prevent growth in employment and output.

However, the difficulty of policymakers is highlighted further when we look at inflation. An easy policy stance would have been acceptable if inflation was low. Food inflation has been a major area of concern for various months. As predicted by many observers, there has been a decline in food inflation in the recent months. However, while food inflation has come down, both on month-on-month and on year-on-year basis, inflation in non-food, non-fuel prices has risen on a month-on-month basis. This poses a difficulty for monetary policy. Non-food, non-fuel inflation is often treated as representative of a ?core? inflation measure, which can be influenced by monetary policy and predicts overall inflation. This measure has been mentioned in RBI?s credit policy as the one that RBI is watching. If core inflation rises, there is a case for raising interest rates.

Many observers have suggested that RBI is ?behind the curve? on tightening its monetary policy stance. In other words, RBI should have raised interest rates sooner. There is also a widespread view that RBI should raise rates soon. However, the data for industrial production suggests that RBI should be extremely careful before monetary tightening. The Indian economy does not often witness an actual decline in output.

If the data for industrial production is indeed correct and represents a true picture, then the policy of tightening is not so obvious. At the same time, high core inflation will make it difficult for RBI to do nothing. The monetary authority has to take a view after giving weight to both inflation and output considerations. Slow growth in output can take the pressure off prices without aggressive tightening. It, therefore, makes sense to take a very cautious view on monetary tightening.

?The author is senior fellow at National Institute of Public Finance & Policy. Views are personal