The Reserve Bank of India also gave little indication that it might cut the cash reserve ratio (CRR), the share of deposits banks must maintain with the central bank, potentially disappointing growing market hopes it would do so.
The RBI left interest rates unchanged in December after raising them 13 times between March 2010 and October 2011.
"The critical factors in rate actions ahead will be core inflation and exchange rate pass-through," the RBI said on Monday in its quarterly macroeconomic and monetary review.
Core inflation, which measures price changes in non-food manufactured products, has been at or above 7 percent for 11 straight months, compared to its long-term trend of about 4 percent, the RBI said.
Adding to inflationary pressures, the rupee fell 16 percent against the dollar in 2011, boosting the cost of critical imports such as oil.
Annual headline inflation, as measured by the wholesale price index, slowed to a two-year low of 7.47 percent in December, thanks to a sharp decline in food inflation. However, manufactured product inflation edged up from the previous month.
"Upside risks to inflation persist from insufficient supply responses, exchange rate pass-through, suppressed inflation and an expansionary fiscal stance," the RBI said, adding that inflation was likely to ease to its target of 7 percent by the end of the fiscal year in March.
Investment in industrial capacity that would ease supply bottlenecks in Asia's third-largest economy has been slowed by sluggish decision-making in New Delhi, while programs that increase the spending power of rural Indians have driven up demand for items such as protein-rich foods.
CRR CUT HOPES DASHED?
Indian government bond yields and overnight indexed swap rates eased on Monday, before the RBI's report was released, on growing expectations that the central bank may lower the CRR.
Of 20 economists polled by Reuters last week, 7 expected a CRR cut on Tuesday. None of 22 expected a cut in interest rates.
The 10-year benchmark bond yield closed 1 basis point lower at 8.17 percent, the one-year swap rate settled 8 bps lower at 7.93 percent and the five-year shed 3 bps to 7.23 percent.
However, some market watchers said the central bank's Monday review appeared to dampen the prospect of a CRR cut on Tuesday.
While the RBI acknowledged significant liquidity tightening since November, it also said "liquidity stress was handled" through open market operations (OMOs), or buybacks of bonds by the central bank.
"This probably provides a sense that the RBI could be happy to continue to conduct OMOs to infuse rupee liquidity at the margin, rather than reducing the CRR immediately, given the risks that are there to the inflation trajectory," said Indranil Pan, chief economist at Kotak Mahindra Bank.
A senior trader at a foreign bank who declined to be identified said Monday's statement appeared to rule out a cut in the CRR, which he said was bearish for bonds on Tuesday.
Others said a CRR cut on Tuesday was still a possibility.
The central bank said that while open market operations have been its weapon of choice for addressing tight market liquidity, other measures could be considered if needed.
"Enabling smooth functioning of other markets by ensuring that the liquidity deficit remains within acceptable limits is also a policy priority," it said.
The RBI said it expected growth to improve in the fiscal year that starts in April, but that weak investment and external demand may keep the recovery slow.
"The growth outlook has weakened as a result of adverse global and domestic factors," it said.
India's economy is expected to struggle to grow about 7 percent in the fiscal year that ends in March, far slower than the previous year's 8.5 percent.
