By shifting its focus to its one-year-ahead inflation target, RBI has more or less convinced the market the current policy rate will hold even as August CPI and WPI inflation have surprised on the down side. Not even the sharp fall in crude prices or the benign global commodity prices would induce it to change its position too soon; so much so that most analysts do not expect monetary policy to ease in 2014. What would be interesting at the forthcoming review however, is RBI?s view on investment revival as concerns of a further slowdown abroad move to the centrestage. Were global growth to falter again, and dent demand for Indian exports, the burden would devolve upon domestic demand, especially investment.

Two important issues surface in this regard. The first is the sagging loan demand, which continues to decline even as GDP growth was 5.7% in April-June. Bankers state corporates? loan demand is near-absent as the latter are still averse to borrowing; still, they expect a 15% growth in bank credit in FY15. If realised on the strength of retail loans, the central bank is bound to fret over bankers pushing consumer loans in an environment of low GDP growth. It could create further NPAs. An effective easing of loan rates, by way of aggressive, competitive offers of home and auto loans, through 20-50 bps discounts, has been reported. Starting with the State Bank of India, banks have begun to lower deposit rates as the gap between deposit-credit growth rates widens. A persistence of such liquidity or technical factors, could even affect bond markets, pressurising deposit rates further.

The second feature bothering RBI would be the retail-wholesale price inflation gap. While both have been declining, the WPI is decelerating at a much faster pace. The divergence in prices faced by consumers and producers, which has historically reverted to its mean (about 1.5-2.5 percentage points), increased the gap in July-August. This presumably reflects lack of competition at retail levels, an area for government action. There is little RBI can do in this regard. But it doesn?t change the fact that producers realising revenues based upon output prices (WPI) face interest costs benchmarked to consumer prices (CPI). The large difference in the two indices hurts them therefore; their inability to pass-through margin pressures reflects the weakness of demand.

Poor loan demand and WPI-CPI divergence would be both serious issues for RBI on the output side. Yet it may have genuine, understandable concerns about inflation. It doesn?t, as the RBI Governor said a while ago, want to lower interest rates only to see inflation return and then have to raise them again. However, there may be circumstances in which RBI could, if unwilling to ease now, start creating conditions for such an action should a comforting inflation scenario materialise.

There are two key price pressure points for the central bank to watch out for at this point. One, resurgence in food price inflation, the probability of which is now increased looking to the monsoon damage to agriculture output, based upon the first advance estimates. Related to this are the second-round effects; on these, RBI needs to reassure that they do not re-emerge. Both are reasonable. The central bank?s views on the second-round effects are critically contingent upon how it sees the interplay between two offsetting factors, viz. higher food prices and significantly softer prices of oil and other commodities. Whether these opposite movements are sufficient to cancel out transmission into future core inflation will be governed by how domestic and global factors weigh upon inflation risks.

The first of these is the global demand outlook. Although the IMF is yet to officially come out with its updated world output forecast for 2014 and 2015, its Managing Director has already indicated these will be lower relative to July outlook. But OECD has slashed its growth forecasts for advanced economies, while China?s slowdown is pushing down oil, commodity and other prices, which are also helped by a strengthening dollar. The dominant trend is deflationary rather than the other way round. It remains to be seen how global growth slowdown impacts India?s exports; and to what extent would it be offset by an increased contribution from domestic investment demand, particularly from cleared infrastructure projects.

Fiscal policy and farm support prices are the domestic factors that could contribute to core inflation. On both counts, the upside risks appear well contained. While the fiscal stance is contractionary and is confidently bound by the consolidation path until 2017, two successive years have seen very modest increases in minimum support prices. As much of the inflation battle is being fought through wage suppression, the continued transmission of weaker impulses from these channels will restrain core inflation ahead. The sharp deceleration in services? sector growth testifies to this.

Sceptics might argue that inflation remains high relative to output; the potential capacity of the economy growing sustainably, i.e., in a non-inflationary manner, is seriously dented by the weak pace of investment on the supply-side in the past few years. This is true. But, it is also a spiral because even though interest rates may not matter as much for investment as other things, there is little doubt that monetary policy does impact aggregate output. And when this weakens so much that it threatens the primary link in the transmission channel, the need is to get out of such a spiral. At this juncture, the emerging question might be: How?

With credit market conditions remaining as they currently are, the growth-inflation dilemma is taking an altogether different turn. The near-term evolution of the transmission mechanism is critical to observe in this context. The conduct of monetary policy would then rest upon the choice between living with a disengaged transmission channel for a longer period or fine-tuning inflation psychology operating from the central bank?s commitment to an inflation target, which in turn influences pricing behaviour to keep actual inflation low.

The author is a New Delhi-based macroeconomist