Adjust demand to reduce price shock

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Every day that goes by sees global oil prices reach new high. On Friday, crude futures increased to $132 a barrel: over the past 12 months, global prices have increased by 90% and Indian prices (measured by the WPI) by 40%. But surely global oil prices cannot keep rising for ever and be a source of permanently accelerating inflation. At some point global oil price inflation will stabilize and so will inflation in India. After all, Indian economic growth is already slowing.

If only the macroeconomic outlook could be that simple. Unfortunately, there are reasons to believe that even if global oil price inflation stabilizes, Indian inflation could remain elevated.

First, while oil price inflation is likely to come down, oil prices are unlikely to fall. This reflects a number of factors, recently highlighted in a speech by John Lipsky, the IMF’s number two. On the supply side, years of low prices and political risks may have led to under-investment in exploration: despite the increase in prices production outside of OPEC has not increased since 2005. On the demand side, there is no sign of a slowdown: according to the IMF, emerging markets, that tend to be more energy intensive than advanced economies, account for 90 % of the increase in oil demand since 2003. And last but not least, low interest rates and a weak dollar, according to IMF research have also contributed to the increase in oil prices (Commodities prices and global inflation, IMF, 8 May 2008).

Second, there may be a need to adjust demand to permanently high oil prices. Indian households’ real purchasing power has come down because they are paying more for energy. Unfortunately India’s income and productive capacity have also been reduced by the higher oil prices. India now needs to export a greater share of its output to pay for its oil import bill. At the same time, manufacturing sector profits are starting to feel the impact of high oil and commodities prices (metal prices are also at a historical high) and as a result the expansion of India’s productive capacity is slowing.