Rising inflation or a prolonged slowdown: which is the bigger threat to the Indian economy over the next couple of years? The answer to this simple question will determine the nature of monetary and fiscal policy in the coming months.

Inflation has been on a roller coaster over the past two years, peaking near double-digit levels around the middle of 2008, then dipping below zero earlier this year and now inching up into positive territory. It seems headed to levels that should concern the Reserve Bank of India (RBI) even as galloping food prices are already hurting the poor who spend a substantial part of their incomes on it and who do not have indexed salaries.

Growth has been more of a one-way journey. The glory days of 9%-plus rates of economic growth are clearly behind us. The most optimistic forecasts say that the economy will expand at around 7% a year for the next few years, a good 2.5 percentage points below the peak levels touched in the 2004-2008 boom. That’s very good compared with what most other countries can manage, yet not good enough to create enough jobs or lift enough people out of poverty.

Both resurgent inflation and sluggish growth are concerns. The issue: Which of the two is the more important threat right now?

Indian policymakers have cut interest rates and increased government spending over the past 12 months in an attempt to support domestic demand and growth in the midst of the worst decline in global trade and output since 1929. But now that both the global and domestic economies are showing some signs of stability, there has been a lot of discussion on how and when they should exit from these loose monetary and fiscal policies.

RBI governor D. Subbarao recently put the policy dilemma in a nutshell, in a speech at the annual meeting of the International Monetary Fund and the World Bank in Istanbul: “We may need to exit from accommodative monetary policy earlier than advanced economies. This calls for careful management of trade-offs: growth concerns warrant a delayed exist, but inflation concerns call for an earlier exit," he said. “An early exit on inflation concerns runs the risk of derailing the fragile growth, while a delayed exit may engender inflation expectations."

Back home in India, Montek Singh Ahluwalia, deputy chairman of the Planning Commission, said: “… once we get to 7% growth and if inflation becomes uncomfortable...we need to look at these exit issues," he said (italics added). Finance minister Pranab Mukherjee said in a television interview: “Monetary policy and fiscal policy should move in tandem. It should not be contradictory."

Reading between the lines, one gets a feeling that the central bank is keener to tighten policy than the government is—a replay of the usual disagreement between a careful central bank and a more incautious government.

One does not know whether this incipient disagreement between RBI and the finance ministry will eventually balloon into the sort of closed-door confrontation that was an open secret during the first Manmohan Singh government. Pranab Mukherjee’s statement that fiscal and monetary policies should move in tandem and “should not be contradictory" suggests he wants the central bank to toe the government’s line.

The real answer to this dilemma depends on whether growth recovers before inflation does, though this seems unlikely right now. The biggest macroeconomic threat is a public finance mess that can be compared with the situation before the crisis of 1991. With that comes an explosion in public debt.

The government has made solemn promises that it will slash its deficit over the next three years or so, which is a must. The record shows that no Indian government has had the political space to cut its fiscal deficit through reductions in spending; and a government that believes it won a national election because of a farm loan waiver and an expensive rural jobs scheme is most unlikely to touch its spending commitments. The only politically acceptable way to, say, halve the deficit as a percentage of national output is to bank on a huge increase in tax revenues. That requires strong economic growth.

I would not be surprised if the government tries to rein in the central bank’s enthusiasm to increase interest rates in 2009, not because it does not worry about inflation but because its own fiscal problems require high growth to propel tax revenues and low interest rates to keep down its cost of debt servicing.

It is good that there is now a serious public discussion on when India needs to exit from its very loose fiscal and monetary policies. That should be enough of a signal to economic agents and the bond market that interest rates will go up and the fiscal deficit will shrink in the next few quarters. But it is also clear that there will be complex trade-offs involved.

In short, there are no easy exits.

Niranjan Rajadhyaksha is managing editor of Mint. Comment at cafeeconomics@livemint.com