Economic growth in India is likely to moderate and fall below the trend rate in 2011-12, with the decline already visible in industrial activity and some service sector industries. However, prospects in the agriculture sector are encouraging with the likelihood of a record kharif crop, the Reserve Bank of India (RBI) said in its second quarter economic review.

With the increasing linkage between domestic industrial growth and global industrial cycle, some further moderation is likely in the period ahead, given the weak global factors, RBI said.

High inflation, RBI said, is likely to persist over the next couple of months before moderating as the rupee fall offsets the benefits of falling global commodity prices.

Food inflation is likely to stay high due to demand-supply mismatches in non-cereals and increases in support prices. And, with real wage inflation extending into the next quarter, the challenges of domestic inflation remains significant, RBI said.

Along with this, there has been a softening of investment demand as a result of a combination of factors like monetary tightening, hindrances to project execution, deteriorating business confidence and slowing of global economy, RBI noted.

RBI noted that capacity constraints seemed to be easing in some manufacturing segments, especially cement, fertilisers and steel. Construction activity has slowed and leading indicators suggest that going forward, service sector growth may also slightly weaken, the review noted.

The low level of aggregate demand has been evident from the significant decline in planned corporate fixed investment in new projects since the second half of 2010-11 and in the first quarter of 2011-12. RBI expects the pipeline of investment to shrink, putting growth in 2012-13 at risk.

Private consumption, however, remains robust overall as is evident from corporate sales performance. While sales growth continues to be healthy, profits are under pressure, RBI noted.

Fiscal slippages during 2011-12 may complicate aggregate demand management, which is key to sustaining growth. Supporting investment by rebalancing demand from government consumption to public and private investment is essential for managing aggregate demand, it added.

Over and above these, the widening of the country's current account deficit (CAD) could decelerate growth of the domestic economy along with the global slowdown. Invisible earnings may also decelerate as slow down in US and euro area could impact software exports, RBI noted.

While the decline in FII inflows has been largely offset by strong FDI flows, capital flows are entering an uncertain phase with increased financial stress and worsening global growth prospects. External sector outlook, although stable, warrants close monitoring, RBI said.

RBI said the current liquidity deficit is planned and in line with the policy objective and remained comfortable. Money (M3) growth, however, moderated less sharply and remained above the indicative trajectory as the money multiplier increased, it added.

Bank credit growth, however, is above the indicative trajectory as it has been supplemented by increased resource flows from non-banking sources. However, going forward, credit growth is expected to moderate as growth slows.

Monetary policy has been significantly tightened since February 2010 with an effective increase of 500 bps in policy rates and a 100 bps increase in CRR, but monetary transmission is still unfolding and real interest rates remain low and non-disruptive to growth, RBI noted.

Rising risk aversion has caused credit spreads to widen. This has been evident in the hardening of the yields on government securities after the announcement of additional market borrowing.

Inflation risk, however, persists and the policy choices for the RBI have become more complex. In this backdrop, the monetary policy trajectory will need to be guided by the emerging growth-inflation dynamics even as transmission of the past actions is still unfolding, it added.