The first thing that I want describe is the word In-deflation, it is combined effect of inflation and deflation. As we know that deflation is always awful for any economy in case of inflation is vice-versa, so In-deflation is the condtion where the forces of inflation and deflation work together

Deflation is rarer than inflation, but when it strikes, it causes destruction all around with falling demand, sluggish investments and widespread unemployment. After a fairly long, buoyant phase, deflationary winds are blowing across world economies.

The Bank of Japan recently predicted two years of deflation. The possibility of the US plunging into deflation cannot be totally ruled out either. Back home, deflation possibilities are being discussed, though only a few economists like Indian Chief Statistician Pronab Sen have gone on record predicting deflation by March 2009.

What really is deflation? And will it happen? Falling prices, if they persist, would lead to a vicious spiral of falling profits, closing factories, fewer jobs and increasing defaults on loans. Right now, for India, a brief deflation is a statistical possibility.

Yes, deflation is likely by the middle of 2009, says Tushar Poddar, economist at Goldman Sachs. What's triggering this deflationary wave, though? Clearly, it's the inflation monster that came crumbling down, crashing from a high of 13 per cent in August last year to around 5 per cent in January 2009. With RBI (Reserve Bank of India) targeting an inflation of 3 per cent by March 2009 and the government announcing further fuel price cuts, there is the possibility of inflation (WPI) reaching zero in the remaining three quarters of this year.

If this happens, the repercussion will be far reaching. Unemployment may increase on the back of lower demand and cut back in spending both by individuals and the government. James McCormack, Head (Asia-Pacific Sovereign Ratings) at Fitch Ratings, says: If consumers expect prices to decline, they typically curtail spending in anticipation of further cuts. This weakens economic activity.

Poddar warns that the common man should be wary of this. If prices continue to fall, then it eventually leads to producers cutting back output, which leads to lower growth and further deflation, he says.

Others disagree. The decline in the fuel and manufactured goods prices has triggered a deflationary scenario, but food prices are still ruling high and they are not expected to fall substantially to sustain a deflation, says D.K. Joshi, Principal Economist at CRISIL. Agrees Sonal Varma, economist at Nomura International Plc, saying: The consumer price index is still high and unlikely to drop sharply. For December 2008, consumer price inflation was close to 10 per cent.

Policymakers are addressing the demand issue on a war footing with two stimulus packages already out. There is a need to cut interest rates aggressively,

The Indian economy is currently being hit by the mother of all external shocks. With the US and the rest of the developed world in its worst recession in 75 years, and the impact being felt on India's growth, employment, exports, asset prices, and rapidly falling inflation, this is not the average downturn in the business cycle.

It is nearly certain, as confirmed by the Government's Chief Statistician, that India will face a period of deflation in the middle of 2009. Most economists tend to think that it will only be a matter of a few months before prices start rising again. Under reasonable assumptions, however, wholesale prices may show year-on-year declines from April through end-2009.

The real danger to the economy is that due to the large negative demand shock, deflationary forces get entrenched, leading to a vicious cycle of falling output and declining prices. To counter this clear and present danger, policy, especially fiscal, will have to use all its firepower to forestall it.

So, is deflation in India really possible and why should we worry about it?

Everywhere one looks, prices are falling. From airline tickets to cars, from household goods to clothes, and from property prices to stock prices, all are seeing declines. The whole sale price index is already showing the largest absolute declines ever since the series started in 1988, falling by 2.5 per cent month on month in October, 4.7 per cent in November, and 3.9 per cent in December.

Deflation hurts the economy much more than inflation, as borne out by the US experience during the Great Depression from 1929-33 when output shrank 40 per cent and nominal prices by 24 per cent, and by Japan's 'Lost Decade' in the 1990s.

Consumers postponed expenditure, because they think prices will be cheaper going forward. This affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.

A temporary period of deflation can become sustained as asset prices fall, the credit channel stops working, and people start expecting falling prices. As property and equity prices fall, they reduce collateral which shrinks the balance sheet of firms and makes banks unwilling to lend, further hurting firms.

If consumer expectations of deflation become unhinged, which can happen very quickly, a temporary phenomenon becomes entrenched.

Although in India's case the supply constraints and traditionally high inflationary expectations militate against deflation, the size of the demand shock demand can outweigh them.

At any rate, policy needs to pre-empt even a small probability of such a grave threat to the India growth story. Policy has to re-inflate and re-ignite demand. It is better to err on the side of inflation rather than deflation.

Monetary policy, although it has been loosened considerably, still has considerable room left to ease. Short-term policy rates at 4-5.5 per cent are still too high, because with deflation on the horizon, real rates will be higher still.

With lending rates still in the 12-12.5 per cent range, real lending rates in India will be among the highest in the region. Given the long lag in transmitting policy rates to bank lending rates and then to overall activity, there is merit in getting policy rates down as quickly as possible.

Monetary policy alone, however, will not be enough. Its effectiveness is constrained due to rising credit risk, which is causing a divergence between policy and bank lending rates. Therefore, cutting policy rates is necessary but not sufficient to stimulate demand. An additional constraint is that at the extreme, nominal policy rates can't go below zero, so during a time of deflation, real rates can remain high.

The onus will then have to fall on fiscal policy. In particular, there needs to be additional stimulus in FY10, over and above the big stimuli provided in FY09. There is an argument that there is no more fiscal space for further counter-cyclical fiscal policy as it would lead to the crowding out of the private sector and could lead to our debt burden becoming unsustainable. Let us examine each in turn.

In the current abnormal environment, the private sector has been crowded out already as banks are not lending to them due to high credit risk. What is of concern is that corporate bond yields are very high relative to government bond yields rather than the level of government yields itself.

Indeed, if monetary policy is further loosened, in an environment of deflationary impulses, government yields can fall further. Additional fiscal stimulus is not part of the problem but part of the solution for corporate.

Although India's debt burden will rise, what matters more for the long-term sustainability of debt is the differential between GDP growth and interest rates. It would be much worse for our debt ratio if growth rates were to be significantly lowered due to the negative shock.

As long as the fiscal expansion is temporary and helps to boost growth, it will not endanger sustainability. India's favorable demographics will also help in bringing down the debt burden. However, the expansion should be carefully calibrated with a medium-term commitment to bring down the deficit when more benign conditions return.

So what form should a fiscal expansion take?

Increased spending by the government suffers from two problems - it takes time to filter through, and there are serious problems in implementation capacity. It is preferable to have a tax cut which is quick, equitable, and can unleash domestic demand from liquidity-constrained consumers. An income tax cut would fulfill all these requirements.

A good start would be to eliminate the education cess on income tax, and provide a one-year holiday on the corporate tax surcharge in the interim budget.