The inescapable choice between controlling inflation and nurturing growth could become more difficult in the coming months—in India and across the world.

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The European Central Bank (ECB) seems set to increase interest rates on Thursday. It will be the first attempt by a Western monetary authority to tighten policy since the financial crisis. Europe is not completely out of trouble as yet. Its two-track recovery means that ECB has to make a tough choice between quelling inflation in the stronger European economies on the one hand and keeping borrowing costs low for the weaker (and highly indebted) economies on the other. It seems ECB is now more concerned about the former than the latter.

The US Fed is also due to wind down its $600 billion bond buy-back programme, aka QE2, by the end of June. Financial markets are watching the Fed closely to pick up any hints about whether QE2 will be continued or not. As of now, it seems unlikely. The latest jobs data also suggests that the world’s largest economy is gradually recovering from a deep recession, though there is also data that hints at continuing weakness in the recovery.

It’s still a mixed picture, so the US may not increase interest rates right away, even though some of the more hawkish policymakers in the US central bank are pushing for a monetary tightening soon. But it seems some discussions about this eventuality seem to have begun, going by a statement made by US Federal Reserve chairman Ben Bernanke in his latest semi-annual report to US lawmakers: “We have all the tools we need to achieve a smooth and effective exit from the appropriate time." And Narayana Kocherlakota of the Minneapolis Fed told TheWall Street Journal recently that an increase in US policy rates of 50 basis points (bps) later this year was “certainly possible".

What is happening in Europe and the US suggests that the coming months will see economies move in a way that forces policymakers to make tough choices between stamping out resurgent inflation and protecting weak growth. The data could get increasingly mixed and the trade-offs more difficult—especially if you add the flare-up in oil prices and the economic dislocation in Japan to the equation.

India chose a combination of very loose monetary and fiscal policies to protect growth in the global panic after the collapse of investment bank Lehman Brothers in September 2008. It did not have to worry about the immediate impact of these expansionary policies on prices because inflation was very low in those months. Then the initial surge in inflation was driven by food prices. Inflation in the prices of goods manufactured in factories remained low.

The subsequent strong recovery from that downturn and the resurgence of high inflation in manufactured goods allowed both the Reserve Bank of India (RBI) and the finance ministry to tighten policy without too many complications. Inflation was the bigger problem than growth in FY2011. The Indian central bank has pushed up interest rates to curb private demand. The finance ministry has promised a lower fiscal deficit to curb government demand.

The new fiscal year that began on Friday could prove to be more complicated in terms of policy making. The focus still seems to be on keeping a lid on demand. The government has plans to cut the fiscal deficit sharply while RBI is expected to raise short-term interest rates between 50 bps and 75 bps this fiscal. The government seems to be confident that such simultaneous tightening of fiscal and monetary policy will not harm economic growth. That’s hard to believe.

In an excellent analysis of the Union budget in the Business Standard, Jehangir Aziz, chief economist of J.P. Morgan Chase in India, had argued that the official assumption that the economy would grow at 9% in the current fiscal does not make sense given the sharp fiscal correction (taking out the bonanza from asset sales in FY11). “So, comparing apples to apples, the planned deficit reduction is from 6.7% of GDP to 5% of GDP—a staggering 1.7% of GDP. Let’s say the general fiscal multiplier is 0.6… This would imply a reduction in GDP growth of around 1%."

The direction of fiscal and monetary policy suggests that Indian policymakers are ready to live with lower growth if it means getting inflation under control. Inflation hurts the poor the most. It can get embedded in the Indian economy if wages start getting bid up. But economic growth seems to be weakening as well. Investment demand has not yet recovered in India. Many private sector economists are less bullish on India than the government is.

In these circumstances, there will be pressure on the government to not meet the tight fiscal target and on the Indian central bank to not increase interest rates to the desired level. It will be a tug of war worth watching.

Niranjan Rajadhyaksha is Managing Editor of Mint. Your comments are welcome at