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.

The difficulty of managing oil price shocks is that aggregate demand, supply and income are all hit at the same time. If aggregate demand weakens by less than aggregate supply, corporates can retain enough pricing power to pass on the higher oil costs to their customers and second round effects can push up inflation further. And if domestic demand does not adjust to the loss of income caused by the oil shock, the external deficit can widen further. In Thailand and Korea inflation is accelerating and current account balances are swinging into deficits, from previous surpluses.

Where is India’s aggregate demand relative to aggregate supply and income? The trade deficit has been stable over the past 6 months. This reflects very strong export growth at more than 30% on average over the past 6 months, and slowing non-oil import growth that have accommodated the increase in oil prices and oil imports.

Slowing non-oil imports growth of course reflect the slowdown in India’s overall GDP growth since the 9.6% peak registered in FY07. Since the policy rate has not been hiked after July 06 and the reduction in the central and state deficits has been very gradual, this slowdown is unlikely to reflect tighter monetary and fiscal policies. At the same time, India’s stellar export performance suggests external demand has not been the source of the growth slowdown either. Rather, slower credit growth, which reflects largely banks higher cost of funding, is likely to explain the growth slowdown.

But there is a risk that the slowdown in aggregate demand has not been large enough to contain the second round effects of higher oil prices. Inflation has been accelerating. A recent revision of the March 15 wholesale price index number has seen year on year inflation climb above 8% for the first time in 3 ½ years. In addition, while global oil prices are still climbing, domestic retail oil prices are far from allowing cost recovery at Indian refiners and distributors. The price increase announced by the government last week may not be enough to contain their losses and more may be needed. For these reasons, Indian inflation could remain elevated even if global oil price inflation starts slowing.

And recent rupee weakness is not helping to contain imported inflationary pressures. Up to January, the rupee had displayed an impressive resiliency in the face of global market volatility. But the rupee has now weakened back to its level of March 07 and India’s forex reserves have not increased significantly since the end of March. At $314 billion they are more than comfortable and India’s external liquidity position remains strong. But flat forex reserves suggest capital inflows have slowed, which has reduced the scope for appreciating the rupee. The risk is that without rupee appreciation, the burden of containing inflation could fall on interest rate policy alone. In such an instance, stabilizing inflation against a backdrop of high and rising energy prices could require multiple rate hikes.