The prospect of a war in Iraq and its impact on oil prices, raises some important questions about macroeconomic management.

For India, this external turbulence comes at a particularly unfortunate time. The domestic macroeconomy has been in relatively good shape for the last few months, with no serious internal threat in sight.

Industry has been recovering; the latest evidence from January suggests that the recovery is widening across sectors. Inflation, excluding petroleum prices of course, has virtually disappeared from the policy radar screen.

This, in turn, has allowed the Reserve Bank of India to persist with its soft interest rate regime, which is an important reason for the industrial recovery; housing activity and consumer durable sales, are clearly responding positively to it.

Additionally, the fall in interest rates  saves the government money, which gives it a little more room to spend.

Finally, the large food and forex reserves, apart from the protective buffer they provide to the economy, have also worked to dampen inflationary expectations, which also contributes to keeping the inflation rate low.

But, should oil prices persist at the level they are at now, this situation is threatened.

Analysis of recent episodes of sharp increases in prices of petroleum products under the administered price mechanism (APM) during the last few years indicates a typical pattern of response.

The immediate effect is a spurt in the inflation rate, but over time, say a few months, the pressure on prices is moderated as industrial activity slows down.

At the end of the process, we are left  with somewhat higher inflation and somewhat lower growth. Of course, the APM has been replaced by a market pricing mechanism now, but all that it means in this context is that, rising crude oil prices will translate into higher consumer prices that much sooner.

This combination of higher inflation and slower growth is, in textbook jargon, called ‘stagflation'. It imposes serious constraints on the policymaker's choices.

These constraints are particularly relevant in the Indian macroeconomic context of today.

The essential dilemma in dealing with stagflation is that it calls for the simultaneous use of both expansionary and contractionary macroeconomic policy.

The former, say by increasing government spending or cutting taxes or lowering the interest rate is warranted by the need to accelerate growth.

The latter, which is to do exactly the opposite, is required to decelerate inflation.

If you expand, you risk setting off an inflationary spiral, which the USA discovered in the early 1970s.

If you contract, you will lower inflation all right, but will have to deal with a more intense recession.

What if you do nothing and simply wait for the shock of higher oil prices to be absorbed by the system?

This is a viable alternative in an economic situation where prices are extremely flexible and the initial impact of oil prices is neutralised by a fall in the prices of resources that are idle because of the recession, notably labour.

As wage demands reflect the new reality, prices overall show a tendency to decline.

This, in turn, reduces the inflation rate and stimulates demand, which helps the growth rate recover. But, the policymaker is taking a risk on the speed with which this sequence of events works.

The more rigidities there are in the system when it comes to adjusting prices, the greater the risk of a do-nothing strategy is.

For a country like India, there is the added concern with pressure on the balance of payments. 1990-91 was a nightmarish combination of a weak domestic macroeconomy and an external crisis.

For this reason alone, it is important to emphasise the very different domestic circumstances today and its implication for the impact of rising oil prices.

Last week, the RBI governor provided a public assurance that the forex reserves would allow us to deal with the situation far more comfortably.

That is certainly so in the narrow sense of not having to worry about being able to pay for the more expensive oil. But, that should not be taken to mean that there will be no adverse macroeconomic impact.

Central banks around the world these days pay attention to something called ‘core inflation', which is essentially the inflation rate net of food and energy prices.

Sharp increases in core inflation are usually the trigger for contractionary measures. So, an immediate spike in inflation primarily due to oil, such as what we have seen over the last few weeks, should not meet with a significant response.

But, the problem is that higher energy prices spread through the system quite quickly and cause an all-round increase in prices which will show up in core inflation and compel the Central bank to make a decision.

The linkage between prices is particularly strong when production capacity utilisation is high, something we are seeing in an increasing number of industries today.

In a scenario in which oil prices rise or stay relatively high for a prolonged period, the RBI would have to make a critical decision on whether to persist with its current interest rate policy or tighten up on liquidity and allow interest rates to increase.

If the choice is to deal with inflation, given the role of low interest rates in the current industrial recovery, through the channels mentioned above, there is no question that it would falter.

If we accept this as a necessary evil, can we fall back on the fiscal route, through increased government spending, to carry the load?

Are the ongoing and planned road construction projects, for instance, enough to keep demand reasonably buoyant even in the face of rising interest rates?

Another dilemma emerges. Higher rates will increase the government's cost of borrowing and force it to re-work its expenditure plans, if it wants to keep a lid on its deficit.

If much of the resources is coming from the private sector, higher borrowing costs will also be a deterrent.

Are there any policy instruments available to deal with a shock of this nature, besides wait-and-watch? Yes. Lowering indirect taxes to neutralise the impact of energy prices on costs of production are a direct way of addressing the issue.

If it works, the revenue losses from lower rates will be at least partially offset by the increase in activity that would ensue.

But, this is a significant risk in terms of lags and magnitudes and could easily aggravate the fiscal situation in the short-term.

In effect, we have moved from a relatively rosy to a potentially bleak situation in a matter of months. Unfortunately, it is in times like this that economics earns its title as the 'dismal science.'