Leap year 2012 appears to have begun well for India's economic policy establishment. Food price inflation, measured on an annual week-on-week basis, which was hovering for many months in the two-digit range, has not just moderated but turned negative. And there are signs that the continuous decline in the annual, month-on-month growth in the Index of Industrial Production (IIP) was reversing itself as of November. Low inflation and growth, even if moderate, should cheer a government that feared stagflation till recently.

However, not everybody is enthused by the evidence. Inflation is not just confined to food articles. And, even in the case of food, there is good reason to believe that the decline in prices is because of the ''base effect'' that plagues week-on-week rates. Inflation rates in any particular week could rise or fall partly because the price index in the corresponding week of the previous year was either unusually low or unusually high. Moving out of exceptional periods of that kind can restore the trend, which in this case is estimated as positive and reasonably high, even if not in the 10 per cent-plus range.

Similar doubts have been expressed with regard to the IIP, which has shown unusual volatility in recent months, though the trend seems to be one of decline. The ‘V-shaped' recovery from the 2009 recession seems to have peaked and reversed itself as far back as February 2010. That was disappointing enough, because the recovery had established India as one among the countries that had quickly put the effects of the global crisis behind it. What is even more disconcerting is that subsequently industrial growth slipped, stabilised for a while, and then registered a sharp downturn. Some believe that the return to a 5.9 per cent growth rate in the month of November may indicate an end to the slowdown. But others prefer to hold back on the grounds that it is too early to arrive at that conclusion.

Despite these uncertainties, the financial media, the private sector and sections of the government are attempting to make much of the end to stagflation and demanding an early response. They are calling on the central bank to reverse its policy of hiking interest rates to deal with inflation. The central bank through 13 hikes over close to two years had raised its reference rate by more than 3 percentage points. This has resulted in higher borrowing costs for all except the big corporates, who can access international credit under the liberalised policy of the government. To that extent it may have adversely affected investment among small and medium businesses. But more important is the effect higher interest rates are having on household spending. Encouraged by the central bank's easy money and low interest rate policy, Indian households have in recent years relied substantially on credit to finance investments in housing and purchases of cars and durables. The resulting increase in demand was an important factor pushing industrial growth.

With interest rates being raised in recent months, this source of demand has been affected adversely, contributing in no small measure to the slowdown. Thus, reversing the interest rate hike is seen as crucial for growth. And the deceleration in inflation rates is seen as affording the opportunity to restore interest rates to acceptable levels.

Even accepting the view that the fall in inflation rates and the rise in industrial growth rates are not statistical phenomena but reflective of a sustainable trend, this argument misses out on important features of the current conjuncture. The period since 2003-04, till the crisis of 2008-09, was an exceptional period in India's post-Independence growth trajectory. Not only did the country transit to a much higher, 8 per cent-plus, GDP growth trajectory, but there were signs that finally industry and agriculture, besides services, were contributing in some measure to that growth. More importantly, this high rate of growth was not running up against serious supply side constraints and resulting in inflation. Rather growth was occurring in an environment of relative price stability. This combination of high growth and low inflation is indeed the capitalist dream, reminiscent of the post World War II Golden Age in America. Poverty and deprivation remained unacceptably high no doubt and employment was hardly responding to output increases, but there was more than a little to please the government.

To appreciate the significance of this combination of high growth and low inflation we need to turn to India's pre-liberalisation, post-Independence history. For long, India was seen as a country that walked the tightrope between food price inflation and balance of payments difficulties. When growth tended to accelerate, pushing up employment, wages and the demand for food, it ran up against a supply bottleneck in the country's still backward agricultural sector. Food price inflation followed, forcing the government to cutback on its expenditures and rein in demand in order to dampen inflationary trends. Simultaneously, high growth increased the import bill of the country that was not too successful an exporter and had limited access to foreign capital. The resulting balance of payments difficulties meant that scarce foreign exchange could not be used to finance imports that would relax the supply constraint and held curb inflation. On the contrary, even without such imports the country faced periodic balance of payments crises. Thus inflation and balance of payments difficulties constrained growth to moderate levels, and the national output fluctuated around that moderate trend.

It was in the 1980s that it appeared that India had partly overcome these problems. As a result of changes in the global financial system, the country obtained greater access to foreign finance in the form of debt and foreign investment flows. This encouraged the government to ramp up its spending, leading to the first signs of a shift out of the so-termed ''Hindu rate of growth'' of 3-3.5 per cent to a GDP growth trajectory of more than 5 per cent per annum. If inflation was a threat, easily accessible foreign exchange could be used to augment supplies through import and rein in prices. However, being based on a sharp increase in borrowing from abroad in a world that had already experienced the Latin American debt crisis, this trajectory proved unsustainable. Foreign lenders and investors turned wary and reduced India's access to foreign finance, making it difficult for the country to meet its foreign exchange payment commitment. The result was the balance of payments crisis of 1991 that temporarily terminated India's high growth trajectory.

What was remarkable, however, was that despite the crisis, the search by cash-rich foreign investors for new markets combined with India's liberal external policies to ensure continued access to foreign finance. Soon growth resumed at rates similar to that achieved in the 1980s.

But that growth was volatile, touching high levels during 1993-94 to 1996-97 and then tapering off and slowing down by the turn of the century. It was only after 2003-04, as noted above, did the economy experience acceleration, leading to the high growth trajectory that India has become known for in recent times. That growth continued without creating balance of payments difficulties because of large receipts from remittances and software exports and because of capital inflows far in excess of India's needs. It also did not result in domestic inflation, partly because India was still partially insulated from global price trends and partly because the nature of growth was such that it did not result in substantial increases in demand for food and agricultural products.

However, over time there was one unexpected development that this growth seemed to culminate in: generalised inflation, with food price inflation being particularly high in some periods. One reason for such inflation was of course the long years of neglect of agriculture. Rapid non-agricultural growth in a context of slow agricultural growth or even agricultural stagnation must finally lead to price increases due to imbalanced growth. Yet, overall, it did not seem to be the case that inflation was primarily the result of demand-supply imbalances. Rather, inflation appeared to be substantially the result of cost push factors, with costs rising because of rising import costs, cuts in subsidies and a growing tendency to calibrate administered price increases to correspond with international prices. All these were in keeping with the ideology of economic reform. The area in which this was most obvious was oil, leading to much controversy. But it was true of price trends for a range of inputs and intermediates, and therefore affected final product prices. It was also true of the minimum support prices at which food grains were procured. The outcome was, of course, that growth was accompanied by high inflation, since India had become an economy characterised by rising costs and rising prices. This was the other side of the policy of liberalisation, which permitted high growth supported by access to foreign finance.

Two features of this growth process and their implications need noting. First, growth during the first decade of this century was driven not by public expenditure but largely by debt-financed private expenditure. Second, this was the period when, as a result of fiscal reform, the government was trimming its fiscal deficit to GDP ratio, unlike during the 1980s when that deficit widened significantly. The implication of the implicit substitution of debt-financed private spending for debt-financed public spending as a stimulus to growth was that the government was less willing to curtail its expenditures to address the inflation problem. In the event, the task of dealing with inflation devolved on the RBI, which resorted to the conventional weapon used by central banks by raising interest rates repeatedly. But this, as noted above, adversely affected debt-financed private expenditure, resulting in the growth slowdown. Households daring to borrow when low interest rates made monthly instalments of debt affordable now withdrew from the market. As a result, India once again seems to be in a world in which sustaining growth with low inflation is difficult to realise. If inflation has to be reined in, it appears, growth had to be sacrificed-a conclusion that is unacceptable to a government obsessed with GDP growth.

It is for this reason that the early signs of a reduction in the rate of inflation have been received with much enthusiasm and the evidence used to make a case for lower interest rates. There is no reason to believe that within the current policy regime this would not aggravate inflationary trends once again. The rate-cut recommendation ignores the possibility that the problem at hand is structural, and that demand compression is a prerequisite for moderate inflation. If that is the case the high growth-low inflation mix that makes India's economy ''shine'' will have to give way. And the many stains that should mar the appearance of the current growth trajectory may come to the fore.

* This article was originally published in Frontline, Vol. 29, No. 02, Jan 28 - Feb 10, 2012.