Economists have developed a taxonomy of the growth-inflation tradeoff: supply- and demand-led inflation, deflation, stagflation, and so on. India seems to have added a variant: inflation led by consumption demand, while investment and capex are sharply slowing down. The numbers need little reiteration; enough articles, opinions and editorals have repeatedly emphasised this. The point that should be emphasised is that the economic picture has become clouded enough, with increasing chances of severe disruptions, to warrant a rethink on the trajectory of policy tightening.

Has there been a material change since the last policy review in June to warrant such an emphasis? Much has been written on the conflicting signals from data streams, which have further added to the uncertainty arising from India?s normally noisy data. However, there is little doubt that domestic consumption demand remains strong for the most part, and this demand is probably predominantly fed by a strong rural economy, and re-distributive fiscal policies. On the other hand, data and anecdotal narrative also point to a sharp investment slowdown, probably the combined effects of the rising cost of funds and of the cumulative policy inertia. Overall, growth momentum seems to have moderated, but not too much.

It might be useful to highlight here one of those conflicting signals: money fuelling domestic demand. Inflation is often considered a monetary phenomenon. Analysts have pointed out that money increments in FY12 have been higher than in FY11. M3 growth in the first quarter of FY12 had averaged 17% (a per cent higher than the RBI?s projection), up from 15% in the corresponding quarter of FY11. However, (I acknowledge this argument as originating from one of my bank colleagues), M3 is probably not the appropriate measure of money. The M1 measure is a better proxy for transactional demand for money, and is comprised of demand deposits (i.e., current accounts) and currency with the public. M1 growth has plummeted from 21% in October 2010 to 9.3% in June. M1 growth also often seems to have a lagged effect on inflation. Draw your own conclusions.

But the more important change since the June Policy Review relates to inflation. Of the two expected outcomes of the policy actions in the June mid-quarter review, the first was to ?contain inflation and anchor inflationary expectations by reining in demand side pressures?. This is the main point of this article: the focus of monetary policy should now be inflation expectations, rather than inflation per se.

Despite having raised rates 10 times by 275 basis points, inflation has remained stubbornly close to or above 9% (as the refrain now goes), but this is more or less on track with the RBI?s projection at the time of the policy statement. This has been the quandary of continuing tightening. However, we think these miss the point. We believe that the June WPI data is an inflexion point in inflation expectations. We are not going to talk about the movements in the swap curves, etc, just the simple point that the reported index number came in 60 basis points below our (and Street?s) estimates, resulting in our earlier end-March ?12 inflation forecast of 7.5% being lowered to 6.5-7%, levels closer to RBI?s earlier projection of ?6% with upward bias?. Incidentally, some research, including Dr Rangarajan?s, although relatively dated, suggests that, for India, an inflation rate between 5% and 7% has a positive impact on economic growth.

What are the fundamentals behind such a change in expectations? This brings us to the second expected outcome of the policy review: ?to mitigate the risk to growth from potentially adverse global developments?. It would be an understatement that these risks have increased. A silver lining in India?s policy struggle with stubborn inflation is the deteriorating condition of the global economy, to which our fortunes have become inextricably entwined. Europe?s sovereign and banking troubles are too well discoursed. Austerity measures there will soon begin to take a toll. In the US, apart from the mortgage and employment weaknesses, the state of the state and local governments? debt remains a concern, (and we do not even consider the debt ceiling stand-off, which will be resolved at the brink of the August precipice). China?s construction-led investment boom has got to slow down.

However, while the outlook remains strained, prospects of a severe enough shock to warrant a significant expansion of stimulus and quantitative easing programmes remain limited; sovereign debt levels will just not permit it. In other words, the fuel for a commodities rally will be absent, making a speculative run up in crude and industrial commodities prices a low probability.

It seems to be the case that ?core? inflation in India (which must include fuel, even with the subsidised products, given the extent to which we rely on imported energy) responds more quickly to global developments than to domestic stimuli. Although it is nobody?s argument that monetary policy will not have an impact (it already has), the darkening clouds over the large global economies will probably give India a limited breathing space, during which other structural bottlenecks constraining capacity addition and utilisation can be addressed.

The author is senior vice-president, business & economic research, Axis Bank. These are his personal views