The Reserve Bank of India is facing a fork in the road for the first time since Governor Raghuram Rajan took office amid much fanfare and started targeting inflation as the central bank's primary mandate.
Rajan has had it easy so far. Inflation has steadily cooled over the past year from nearly double digits to under five percent owing to a slump in global crude oil prices. That has given him room to cut interest rates to help economic growth improve.
He has cut the repo rate three times since January, two of which were surprise moves - the latest move a 25 basis point cut to 7.25 percent last week.
But inflation expectations have begun firming up again, a Reuters poll found, on higher crude oil costs and in anticipation of food prices surging soon due to poor rains, while the economy shows scant signs of picking up.
In a country that has historically struggled to keep price rises in check, alarm bells over such pressures have started to sound.
If prices do start rising at a faster rate, Rajan will have to choose between sticking to his inflation mandate in the medium-term or driving growth.
The RBI in June raised its projections - suggesting inflation could be at six percent by January 2016 - but still cut the repo rate.
India has already downgraded this year's monsoon forecasts; in the past, droughts have sent food prices soaring.
Jyotinder Kaur, economist at HDFC Bank in New Delhi, said:
My bet is that the RBI will have to choose sooner rather than later (between inflation and growth).
Given the weak growth conditions, even a slight detour above the RBI's inflation projections in the very near-term is something the RBI may be able to tolerate because it may see this as a temporary phenomenon.
Globally, bond yields have been rising over the past month. German Bund yields in particular have risen sharply, up over 80 basis points from near zero as long-term inflation expectations rose for the euro zone.
India's benchmark bond yield has also risen substantially over the past week, suggesting financial markets are pricing in expectations of higher inflation.
If the Federal Reserve hikes interest rates, most likely in September, monetary policy in the U.S. and India will be left on divergent paths, especially if the RBI were to cut rates again this year.
That would push the Indian rupee to its weakest in years, according to foreign exchange strategists.
The RBI has been building up its foreign exchange reserves in preparation for a Fed rate hike this year, but a weak rupee would see import bills rise and fuel inflation.
But India's situation perhaps is not as bad as some of its global emerging market peers, like Brazil.
Brazil's central bank has already increased its interest rate by 2.75 percentage points - to an eye-watering 13.75 percent - since October and may hike it higher, even though the economy is expected to shrink at least 1 percent this year.
Consumer inflation, which released today, rose to five percent in May from 4.87 percent in April.
Rajan, however, is still is expected to cut rates once more this year, according to economists in a Reuters poll conducted just after the RBI cut the repo rate to 7.25 percent last week.
Some predicted it would happen as early as the next policy review meeting in August.
While inflation is set to stay below the RBI's short-term goal of six percent by January 2016, another rate cut this year could hurt the bank's ability to meet its medium-term target of four percent inflation, plus or minus two percent.
Shilan Shah, India economist at Capital Economics, said:
The (RBI) is probably attempting to achieve both; the growth story in the near term and then medium-term inflation is the bigger picture.
It's more the medium-term where it might be difficult to justify a really aggressive loosening cycle. At the moment the RBI is probably trying to front-load its cuts and boost growth in the near term and then the focus will turn to trying to achieve its medium-term inflation target.
There is a sense that it is loosening policy as much as possible without it becoming reckless.
Rajan's constant reiteration of his mistrust of a new GDP data series, which shows India growing at 7.5 percent at last measure, making it one of the fastest growing economies in the world, along with pressure to ease policy from a government that is trying but has thus far failed to deliver on a reform agenda, is complicating his inflation-targeting stance even further.
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