Over the past two years, the Reserve Bank of India (RBI) was raising rates in a futile effort to contain stubborn inflation, as the government fumbled on fixing decrepit infrastructure and other supply bottlenecks in the economy.
Now, it has switched to pumping huge amounts of cash into the banking system to cool another government-led crisis, a funding crunch caused by heavy public borrowing to finance popular subsidies on fuel and other goods.
For the RBI, 2012 is shaping up as another year of damage control for a populist government's excesses rather than pursuit of its own priorities of boosting investment and containing inflation.
This could leave the economy trapped in an unhealthy confluence of high inflation and slowing growth, with little the RBI could do -- other than easing bank funding -- to encourage investment or to direct cheaper money to the most stressed parts of India's supply chain.
"It is a mistake to look at the RBI always as a vacuum cleaner for the mess the government makes," said Rajeev Malik, senior economist at CLSA Singapore. "The government needs to be more accountable.
"I agree that politically (the RBI) doesn't have the teeth to bite. But there is so much dirt being shoved under the carpet that it is coming out the other side."
Unbridled spending
Fresh from a debacle in state elections, the ruling Congress-led coalition is likely to fill its budget for the next 12 months, to be unveiled on Friday, with more sops and unbridled spending on populist measures such as free food and cheap fuel, doing little to address India's deeper economic ills.
Even if the Congress party were to grapple with tough reforms to shore up tattered government finances and improve crumbling infrastructure -- with 40% of the country's food production perishing before it reaches consumers -- it would be unlikely to get support from its recalcitrant coalition partners, let alone the opposition.
The central bank has been forced to step into this policy vacuum, announcing in quick succession two large reductions in mandatory reserve levels for banks.
The latest, last week's surprise 0.75 percentage point cut in the cash reserve ratio, was meant to ease a cash crunch in the banking system that progressively worsened over the past year as inflows into the country dried up and inflation eroded savings.
To RBI-watchers, the central bank appeared to have made a secondary goal -- ensuring the banking system is liquid and able to lend -- a priority over price stability, albeit reluctantly given worries about high oil prices.
"I think the RBI will have to go with a dovish stance now," said Sanjay Mathur, head of research and strategy at Royal Bank of Scotland.
"There will be huge pressure on the RBI to cut rates as it is easier for the RBI to cut rates than for the government to reduce borrowing."
Policy rates were raised 13 times since March 2010 to bring down double-digit inflation. That sharp rise in the cost of borrowing has taken a heavy toll on economic growth.
On average, economists estimate growth in the fiscal year ending in March 2013 will be 7%, a far cry from the 9% pace of expansion that policymakers in Asia's third-largest economy had taken for granted just a year ago.
Uphill battle
It might make sense, economists said, for the RBI to admit to the futility of its battle against inflation -- which is largely due to supply bottlenecks and high oil and commodity prices, and has anyway stabilised in recent months around 7%, albeit still well above its comfort zone of 4-5% -- and try instead to push up the pace of growth.
"The RBI's actions on the CRR (cash reserve ratio) and bond purchases don't suggest that inflation is a top priority," said Hitendra Dave, global markets head at HSBC India.
"They have taken cognizance of the fact that inflation is headed in the direction they want but growth can create a two- to three-year problem."
Three of 20 economists polled by Reuters expect a cut to the repo rate, India's main policy rate and now at 8.5%, when the RBI reviews policy on Thursday.
"Given the growth outlook and inflation outlook for the year ahead, the repo rate at 8.5% would be too restrictive," said A. Prasanna, economist at ICICI Securities Primary Dealership and one of those forecasting a rate cut.
"While global oil prices pose some upside risk to the inflation outlook, I expect the RBI to view the recent rise as driven by temporary supply-side factors," Prasanna said.
The cut in the cash reserve ratio should ease banks' struggle with a shortage of cash in the system, where the average daily deficit has run as high as 2 trillion rupees.
But the central bank faces an uphill battle to boost growth.
There's plenty of evidence that RBI Governor Duvvuri Subbarao's prolonged fight against inflationary pressures, which were beyond the control of demand-side monetary measures, did more damage than good to the economy.
One side-effect was to lock in high funding costs for most banks, which tried to attract deposits with high fixed rates and may now be reluctant to pass on any immediate rate cuts to customers.
Lower rates may also merely make it easier for a spendthrift government to borrow more, further crowding out the sort of investment the faltering economy badly needs.
What's more, the multitude of woes afflicting the economy, from poor infrastructure to policy uncertainty, have dampened businesses' appetite for loans.
The incremental credit-deposit ratio, which reflects fresh demand for loans in proportion to deposits, slumped to 76.6% in the period from April 2011 to this February, compared with 95.5% in the same period last year.
