Adjust demand to reduce price shock

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: 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.