Wonders will never cease to happen. Inflation at a two year high is making headlines but, surprise, surprise; it is causing very little concern. The usual fuss is totally absent. Why? Largely because inflationary expectations are low.

It's like this - what you, me and every Tom Dick and Harry believes will be the inflation rate in the future impacts the current inflation rate. It's quite simple, if you expect that the price of Onions will go up next week, you rush down to the market and buy some today. On the way back home you tell you neighbour about this and not wanting to be left behind he rushes to the market as well. Pretty soon everybody is rushing to the market to buy Onions and the price of Onions goes up today because everybody is expecting it to go up next week. And this can become an inflationary spiral in which prices continue to rise only because everybody believes that prices shall go up in the future.

Your next question is likely to be, is there any way to track inflationary expectations that does not involve going down to the local market place and observing the goings on in the market? Sure there is. The best indicator of inflationary expectations is the level of interest rates. Ordinarily, when inflationary expectations are high, there is likely to be an upward pressure on interest rates. For the simple reason that interest rates move in sync with inflation. High inflation-High interest rates and Low Inflation-Low interest rates - that's the norm.

In fact even if the inflation rate is not impacted by higher inflationary expectations, as is very often the case in India, the interest rate is impacted because people are willing to save only if they expect the purchasing power of their money to grow at some positive rate. So if inflationary expectations are very high it pushes up nominal interest rates (the published interest rates) so that the real interest rate (nominal rate-inflation rate) on savings is positive.

But right now, despite high inflation rates, there is a general view that interest rates are too high and ought to be lowered. It is this, more than anything else, which suggests that inflationary expectations are low. Of course, there is always a divergence between savers and investors. Naturally, savers demand higher rates. Equally naturally, borrowers of capital bay for a lower cost of capital. But, regardless of this, interest rates are nearly the same -- or even lower -- compared to the last two years when, in fact, inflation was much lower.

The low inflationary expectations are mainly because the current spurt in prices has been fuelled by the sudden and sharp increase in international oil prices, which in turn, led to increases in domestic prices of petroleum products. Inflation, as measured by the wholesale price index (WPI) has risen to over 8%. This is because Fuel and energy costs, which have a weight of less than 15 percent in the WPI have risen by over 30 percent over last year's prices.

But now that the increase in oil prices is under control, it is believed that inflation is no longer an imminent danger. Of course, the recent decision by OPEC to cut oil production may push oil prices up again. But, hopefully, they will remain under $28 per barrel.

The two other product groups in the WPI, primary commodities, manufacturing have a combined weight of over 85 percent -- and they have risen only by 3-4 percent. This also implies that it is not an economy-wide phenomenon resulting either from excess demand (more people rushing to the market) or excess money supply (more money in everybody's wallet) but is due to a specific increase in a volatile commodity (Oil).

So it is also useful to look at what is called "core inflation". This is measured by the rates of change in WPI minus the rates of change prices that may be very volatile, or by taking out the prices that are administered by the government. In the US, some economists choose to subtract the prices of food and fuel.

In India, a possible measure of core inflation was first discussed during the onion price increase in 1998. The sharp increase in onion prices pushed up the WPI more than that the Consumer Price Index (CPI) because the food and primary products group had a higher weight in the CPI. The general point then, too, was that price increase was not generalised or economy wide. Though the political consequences were dramatic.

Apart from the political aspects, core inflation has a serious economic implication as well. This arises from the fact that if inflation is economy wide, it implies a need for checking demand (stop people from rushing to the market) and tightening money supply (reduce the amount of money in their wallets). To contain demand the government can cut expenditure, raise taxes and reduce fiscal deficits. Money supply can be tightened by raising the cash reserve ratio, raising interest rates or by cutting central bank lending to the government (which amounts to nothing but printing currency notes to satisfy the government's needs).

But the only way to find out if the inflation is generalised or confined to some product groups -- onions or oil, it doesn't matter -- fiscal and monetary policy makers need to monitor core, rather than headline, inflation.

One of the main factors responsible for the current slowdown in Indian industry has been identified as a slowdown in demand. A low core inflation rate supports the view that the risks of an expansionary fiscal and/or monetary policy pushing up inflation are limited. In other words, the economy may be able to support a higher fiscal deficit and a higher money supply or a cut in interest rates as they may push growth without pushing up the inflation rate.

Expansionary fiscal policy may be what we need As the government and RBI try to balance pressures from different sections of society interest rates may or may not be cut. But it is possible that despite the higher current inflation rate, the economy can afford a somewhat more expansionary fiscal policy (tax cuts, higher deficit) and monetary policy (lower interest rates, lower cash reserve ratio etc.) in the coming months without apprehensions of a general price increase.

For instance, on the fiscal front if the government were to give a kick start to private investment and reduces taxes (a good way of doing this may be to remove the surcharge on corporate and individual income tax) it would be an called and expansionary fiscal initiative as it would increase the fiscal deficit but at this point in time such a thing can be done because core inflation is low.