Factor in higher oil prices and inflation isn’t as low as it looks

Factor in higher oil prices and inflation isn’t as low as it looks

Numbers often hide more than they reveal. The recent fall in Indian inflation numbers is a case in point.

The inflation rate, as measured by the wholesale price index (WPI), hovering at around 3%, masks the fact that the government is yet to raise domestic prices of petroleum products, despite the sharp rise in prices of international crude from $35 (Rs1,624.35 then) last year. On Wednesday, New York light sweet crude touched $99 a barrel.

This suppression, say economists, means that the effective inflation rate, once the increase in prices of petroleum products are factored in, would be around 4-5%.

Meanwhile, Indian inflation, measured by the WPI, fell to 3.11% in the first week of November, a little higher than 2.97% touched a week ago, the lowest in five years.

This is mainly because of oil prices. The energy group index in the WPI, which rose by an average of 5.7% in 2006-07, declined by 2.6% in September and 1.7% in October; the government had recently rolled back domestic fuel prices.

“It’s ironical that while the global crude prices are touching $100, domestic inflation in the fuel group is negative in India," says Dharmakirti Joshi, principal economist with domestic rating agency Crisil Ltd. “Our estimate is that WPI-based inflation has been kept suppressed by about 100 basis points by not revising the domestic fuel prices."


Even food prices, the main contributor to inflation in 2006-07, have risen slower of late, largely due to good rains and improved supply of foodgrains to the market.

Supply glitches led to food prices climbing steeply by 9.7% in July, hardly lower than the record 10% in January-March. Since then though, food inflation has slowed to 5.4% in September and further to 3.5% in October.

But, the lack of revision in oil prices as well as “other pressures emanating from excess liquidity in the system are continuing to whet inflation expectations," says Joshi. In its mid-year review of the monetary policy last month, the Reserve Bank of India revised its medium-term inflation target downwards to 3%, saying it wanted to condition inflationary expectations in the range of 4-4.5%.

According to Chetan Ahya, an economist with investment bank Morgan Stanley, “the current weighted average crude oil realization implied in domestic oil prices is about $54 per barrel compared with the current international market price of $96. Even with a 5% domestic price rise, the subsidy burden will rise to 1.9% of the GDP, and will imply an expansionary fiscal policy in terms of more oil bonds."

Ahya estimates the subsidy burden on the government to touch $9.3 billion in 2007-08 if global oil prices stay at current levels until March.

The government, says Sanjiv Pohit, senior fellow at independent think tank National Council for Applied Economic Research, “cannot avoid an oil price hike for long. Already, the WPI is showing signs of a heated-up economy. Inflation in capital goods, for instance, has been close to 8% in the first half, compared with 3.7% in April-September 2006. This clearly reflects a surge in demand owing to the high growth momentum. There are too few capital goods chasing the demand".

This year’s inflation, which economists say is set to rise after this current “misleading" break, could thus be more demand-driven than in the last fiscal which was primarily food-supply driven.

Globally, food and some other commodity prices have started edging up in response to an unprecedented demand boom from countries such as China and India.

Consumer price indices, meanwhile, are still around 6.5-8% because food items have a weightage of 60% in these indices.

Thus, inflation rates may temporarily remain low because of the higher base effect factor, since inflation began to firm up around October last year, but “will wear off next year," says Joshi.

Also, as Saumitra Chaudhuri, member, PM’s Economic advisory council says, “core inflation (overall WPI inflation less energy and food inflation) still remains high, around 5%".

The main reason for the high core inflation in India is largely because of firm prices of non-food primary articles, such as oilseeds and metals and minerals, which are subject to pressures of global supply-demand imbalances.

This is in sharp contrast to the situation in China, where inflation has been led by food prices and core inflation is just 1%. India, according to Chaudhuri, “as an economy has had a structurally higher inflation rate than East or South East Asia and, therefore, has faced additional problems on account of large capital inflows."