Commentators have been surprised that the Reserve Bank of India (RBI) did not raise its rates by 50 basis points when it made its monetary policy announcement on Tuesday. After all, with its forecast of 7% inflation at the end of March 2011 and its policy rate at 6.5%, it could be argued that monetary policy is too loose.

Also See | Money supply is tight this year (Graphic)

RBI’s response has been to say that it expects the rate of inflation to be lower in the next fiscal year. According to RBI’s survey of professional forecasters, wholesale price inflation in 2011-12 will average 6.6%, down from an average of 8.5% this fiscal year. But there are few comforting words about inflation in the policy statement. Indeed, the section on inflation reads like a litany of woes and several reasons are advanced why inflation is likely to remain high.

Also Read | Manas Chakravarty’s earlier columns

But has monetary policy really been very loose? The growth in money supply (M3) this year has been forecast by RBI at 17%, while nominal gross domestic product (GDP) growth is likely to be around 17% (8.5% growth + 8.5% average inflation). In other words, if RBI’s forecast of money supply growth is correct (and there’s no reason why it shouldn’t be—M3 growth at end-December 2010 was 16.5%) then M3 growth is just sufficient this year to take care of the increase in nominal GDP and there’s no excess liquidity. In fact, could this be one of the reasons for the current lack of liquidity in the money markets?

Contrast this lack of excess liquidity to the situation prevailing in the last few years. In 2009-10, the gap between M3 growth and growth in nominal GDP was 4.5 percentage points, in 2008-09 it was 3.5 percentage points and in 2007-08 it was as high as 6.4 percentage points. Going by the supply of money alone, monetary policy at the moment does not appear to be too loose.

But growth in non-food credit is much higher than in the last few years. Non-food credit was growing at a y-o-y rate of 24.1% at the end of December 2010, but RBI has kept its forecast of non-food credit growth unchanged at 20%. In 2009-10, non-food credit growth was 16.9%, in 2008-09 17.5% and in 2007-08 it was 22.3%. But it grew by 28% in 2006-07, so perhaps all that the high growth of credit indicates this year is that last year’s base was low and that nominal GDP growth is higher this year.

Nevertheless, RBI has left its forecast for non-food credit growth at 20% for this fiscal year and is jawboning banks to trim credit in order to keep their credit-deposit ratios at sustainable levels, thereby easing liquidity pressures. That’s an acknowledgment that current three-month commercial paper rates of over 9% are hurting firms. But a reduction in the pace of non-food credit growth from the current 24% to 20% by the end of March will imply a steep deceleration in credit growth. That will not only have a negative effect on economic growth but is also not good news for banks. While banks have been able to stave off margin pressures in the December quarter, they may not be able to do so in the next few quarters and if credit volume growth too is lower, bank profits may take a hit.

RBI’s monetary policy statement clearly spells out the risks, not just to inflation remaining at an elevated level, but also to growth. This is what it had to say: “The combined risks from inflation, the CAD (current account deficit) and fiscal situation contribute to an increase in uncertainty about economic stability that consumers and investors will have to deal with. To the extent that this deters consumption and investment decisions, growth may be impacted. While slower growth may contribute to some dampening of inflation and a narrowing of the CAD, it can also have significant impact on capital inflows, asset prices and fiscal consolidation, thereby aggravating some of the risks that have already been identified."

What the central bank seems to be saying here is not just that we will have to live with high inflation and slower growth. What it also says is that inflation (and therefore higher interest rates) may deter consumption and investment, thereby affecting growth. Lower growth in turn could turn off the foreign institutional investor tap, lead to lower stock prices and affect tax collections, thus affecting the fiscal deficit, which again could lead to higher inflation.

Faced with such a difficult scenario, all that RBI can do is confine itself to prevent “food and energy prices from spilling over into generalized inflation and anchoring inflation expectations". It’s an admission that it has no magic bullet.

RBI’s policy statement underlines the headwinds the country is facing and that real reforms are needed and can no longer be put off. Recall the 17% rise in the Sensex on 18 May 2009 on hopes a United Progressive Alliance government minus the Left will push through reforms? That hope has been almost entirely belied.

Graphic by Yogesh Kumar/Mint

Manas Chakravarty looks at trends and issues in the financial markets. Comment at