By Himank Sharma and Neha Dasgupta
MUMBAI (Reuters) - India must focus on keeping inflation low and avoid using monetary policy alone and short-term government incentives to fuel short-term economic growth, the country's central bank governor said on Friday.
Reserve Bank of India Governor Raghuram Rajan is under growing pressure, from industry and from within the government, to cut interest rates as India's economic growth stutters and inflation cools.
On Friday, Indian markets rallied as investors bet there would be a cut this month after the U.S. Federal Reserve kept interest rates on hold.
Rajan said monetary policy can help strengthen the current economic recovery, but he added India will ultimately "expand sustainable growth potential only by continuing to implement reforms the government and regulators have announced."
"For us at the RBI, the key tasks are to keep inflation low, not just today, but well into the future," he said in a lecture organised by the Confederation of Indian Industry.
Analysts said Rajan's remarks left open chances for a rate cut, without feeding speculation.
"What he is trying to do is temper expectations," Vijay Sharma, senior executive vice-president at primary dealer PNB Gilts Ltd in New Delhi.
India's consumer inflation in August hit a record low of 3.66 percent. Rajan, however, attributed that to a favourable base effect and said retail prices would have grown around mid-5 percent without that positive comparison.
The RBI has a consumer inflation target of 2 to 6 percent.
Rajan used Brazil as a "salutary lesson" in how the wrong policies - including using low rates to fuel unsustainable growth and government policies that favoured only some sectors - can impact emerging markets.
He noted Brazil's current fiscal and economic woes today came after the country "tried to grow too fast".
Although Rajan said India was far sturdier, calling it "an island of calm in an ocean of turmoil".
Most analysts expect the RBI to cut rates this month, but doubts remain about how much lower they can go, given the RBI has projected consumer inflation will rise again to 6 percent by January.
Currently set at 7.25 percent, a quarter percentage point cut in the repo rate would reduce it to its lowest since May 2011. The RBI has already cut the policy rate by 75 basis point so far this year.
Analysts said the RBI would likely continue to monitor how much banks pass on existing rate cuts, the Fed's policy, and the pace of government reforms to determine future action.
(Writing by Rafael Nam; Editing by Clara Ferreira Marques and Simon Cameron-Moore)
