The frenetic pace of activity in modern economies and financial markets does not easily enable one to focus on the fundamentals in economic policy making. But coming to the close of a year during which inflation registered sharp increases (and still remains, uncomfortably, above double digits), no time than the present is appropriate to focus on the fundamental objectives of economic policy making. The popular understanding of economic policy is also built on such a clear focus on the basic objectives.

At the ground level, what we want is for the economy to grow, output to rise, unemployment to be low but we also realize (or do we?) that if growth is too robust, there is the risk of inflation rising. The basic objective of policy therefore is (or rather should be) to create the conditions for non-inflationary growth in the economy. Policy makers would ideally prefer the combination of low inflation and expanding real economic growth. By the same token, what they would fear or even dread is declining or stagnating output but stubbornly high inflation.

Speed limits to growth

How is India placed in this regard at the current juncture? Do we have the environment - meaning the mix of monetary and fiscal policy - in place for attaining the combination of robust economic growth but still low and stable inflation? Or, do we face the danger of the prevailing high level of inflation getting entrenched such that only a severe recession / crash landing in the economy can tame the price level? Equally dangerous can be the combination of a slowing real economy (meaning say lower industrial output, higher unemployment) but persistently high inflation.

This question assumes special importance at the current juncture for it appears that the extremely robust performance of the economy in the past 5 years seems to be applying tremendous pressure on the availability and cost of (real) resources such as labor, capital and land. In other words, resource demand and utilisation has been so intense that the economy seems to be bumping against some speed limits and this is getting reflected in very high prices for those resources and in turn, the general price levels.

As the accompanying table shows, we have had a phase of fairly rapid growth in the past 5 years - average GDP growth in the 5 years to 2007-08 was 8.65 per cent, much higher than the 5 per cent growth recorded in the previous 5 year period up to 2002-03. Such a pronounced upward shift in the level of real economic activity has been duly reflected in the price levels - WPI inflation averaged slightly more than 4 per cent in the period up to 2002 but has since moved sharply to average 6 per cent in the past 6 years. The sharp jump into double digit inflation from early this year means that there has been a severe aggravation of the price pressures in the recent past. This will likely mean that the 2 per cent jump in average inflation in the period 2003 to 2008 (from the earlier 1997/2002 period) may just be the tip of the ‘inflation’ iceberg (or rather volcano) we may possibly see in the ensuing period.

No trade-off between growth and inflation

But, why should we bother or worry so much about rising and volatile inflation as long as higher economic growth is produced? Will not the higher growth pay for itself? This has been a staple argument against an economic policy framework which focuses on producing low and stable inflation.

Unfortunately, economic history and cross-country empirical evidence does not show that robust real economic performance can be maintained in the presence of rising / volatile inflation. It has been seen that once higher inflation expectations get entrenched, whatever increase in output / GDP growth which was obtained initially is also lost and the economy slides to a lower level of performance. In other words, there is no trade-off between growth and inflation. The speed limit of the economy can be increased only over a period of time, and one of the crucial requirements for that is economic policy with a clear focus on achieving low and stable inflation. The recent rapid fire moves of economic policy makers to ease liquidity / lower interest rates does not seem to fit that framework.