Pause in response to building downside risks to global and domestic growth? Or press on with its long-established campaign of lifting policy rates to combat inflation? That, in a nutshell, is the policy choice facing the Reserve Bank of India (RBI) at its latest policy review meeting next week.

The case for a pause is twofold. First, the latest intensification of the European debt crisis, which is now taking on an existential aspect as contagion spreads to Italy, has sharpened the downside risks to global growth. And the US’ toxic domestic politics now risk a further, and wholly avoidable, additional shock to the world economy if a deal on the debt ceiling is not reached soon. Worryingly, the politicians’ shenanigans are now denting consumer and business confidence. Latest readings on consumer confidence, for example, showed an alarming fall; a development that threatens to short-circuit the anticipated reacceleration of the US economy in the second half of the year as drag from higher oil prices fades.

Second, tentative evidence that RBI’s steady diet of rate increases is beginning to impact domestic demand is now accumulating. Examples include further softness in the volatile official industrial production data, slippage in the more reliable Purchasing Managers’ Index survey on manufacturing (though its services sibling showed improvement in June) and increasingly sluggish domestic vehicle sales as passenger car demand in particular is crimped by higher fuel costs and tighter credit conditions.

Heightened global uncertainties and early signs of cooling domestic demand are respectable arguments for a time-out by RBI, particularly as the lagged impact of past policy moves may not have been fully felt. But the inflation outlook has similarly continued to deteriorate even as downside risks to growth are increasing. The economy has moved into overheating territory over the last year. Nominal GDP (gross domestic product) growth in calendar 2010, for example, was in excess of 20%—the strongest since 1973! Incoming inflation data continue to reflect this reality. With the economy operating above its short-run productive capacity, cyclical demand-pull inflation is unhelpfully exacerbating the economy’s more intractable structural food inflation problem.

Wholesale Price Index-based inflation, for example, is estimated at almost 9.5% in June, led by accelerating manufacturing inflation and recent fuel price increases. And thanks to WPI’s poor initial response rate, June’s “real" inflation rate is almost certainly far higher as the back data continues to experience serial upward revisions averaging up to 1 percentage point. April WPI inflation was lifted to 9.74% from 8.66%. Revisions are typically pro-cyclical so the upward revisions will eventually peter out, but probably not for some time. RBI will, therefore, almost certainly discover in a month or two that “real" WPI inflation in June was above 10% and that its inflation forecasts, already over-optimistic, have been blown further off course. Despite favourable base effects and the welcome progress of this year’s monsoon so far, WPI inflation could easily be 8% rather than RBI’s current forecast of 6%.

The only remedy for demand-pull inflation is of course a sustained period of below-trend GDP growth which in turn necessitates genuine restrictive policy settings. While both the economy’s trend growth rate and neutral level of policy rate are by definition unobservable, GDP growth well below 8% and policy rate above 8% are reasonable rules of thumb for the RBI. With the repo rate currently at 7.5%, policy settings are just beginning to creep towards restrictive territory, suggesting it is too soon for the RBI to relax. Just as a good doctor should not stop treatment at the first signs of a patient’s improvement, nor should RBI slacken its anti-inflation resolve until a more clearly decisive and sustained slowdown is palpably in train. Pause or press on? The answer is hopefully clear.

Richard Iley is chief economist for Asia Pacific excluding Japan at BNP Paribas SA. These are his personal views.

On 26 July the Reserve Bank of India will announce its quarterly review of monetary policy. Will it continue to tighten the policy with yet another rate hike to fight high inflation or will it press the pause button as growth is being threatened? This is fourth of a series that Mint will carry over this week in the run-up to the policy.