Oil shocks and inflation: A story of shifting vulnerabilities

In India, however, historical high single-digit rates of inflation had halved in the late 90s but hit double digits in 2008, like during the early 70s’ oil shock. That oil price shock predated the global financial crisis, and after a brief crash coinciding with it, oil prices rose again and stayed at a high plateau until 2014. Such shocks raise costs across a broad range of sectors, but for sustained inflation, wages also have to rise. The latter is more likely if food prices also rise in a country where food makes up a large share of its consumption basket, as in India. As high input prices sustained food inflation, India was unable to withstand the combination. Wages rose and second-round effects set in.

India was an outlier then, since inflation stayed low in most countries, especially in advanced economies (AEs), despite quantitative easing. Food has a low share in AE consumption baskets.

Although world food prices had started rising in 2002, following oil prices, Indian food inflation remained low, partly because minimum support prices (MSPs) rose only marginally in this period. Food stocks fell to an all-time low. But MSPs rose rapidly from 2006-07, as the discipline on procurement prices imposed by low border prices had gone. In 2010-11, both food stocks and inflation peaked.

There was a willingness to sacrifice output to reduce inflation peaks. Sharp policy-led demand contractions reduced output growth for each oil-shock but were most successful in reducing inflation when food price inflation remained low.

Administered domestic fuel prices neither rose nor fell as much as international, but cumulative Indian fuel inflation much exceeded global levels. This ratchet effect contributed to Indian inflation. It was one among other cost-push factors creating low chronic inflation.

After minor falls from 2005, as prices became market determined, the large fall in 2015 was still less than that in international prices since oil taxes in India were raised. Nevertheless, it contributed to achieving the country’s inflation target.

Will history repeat? The Ukraine war has sustained the current oil shock as well as aggravated inflation in food items and other commodities. Is this combination going to create persistent Indian inflation as it did in the 2010s? There are risks, but also differences. The war continues, but growing Indian diversity means any challenge creates some opportunities as counters. Higher border prices help the farm lobby raise MSPs. The current wheat price spike is raising domestic prices, for example, but is temporary. Most Indian agricultural prices have reached or are above border prices, limiting the rise in MSPs. Farm lobbies now ask for protection. More trade influences prices. Exports have risen as agricultural productivity, marketing infrastructure and coordination have improved.

Other supply-side actions are reducing cost-push factors. This converts what used to be a permanent cost-push into a temporary shock; in the US, covid supply-side bottlenecks are becoming permanent because of excess fiscal stimulus and tight labour markets. Therefore, Indian inflation differs from that in the US and need not follow the latter.

Oil intensity continues to fall: Moreover, India is now under a flexible inflation targeting regime. Policy rates of interest have to rise, to keep real rates near equilibrium, if inflation is expected to be persistently above the tolerance band. This assurance of a reaction helps anchor inflation expectations. But, under supply shocks, there is an output sacrifice from disinflation. This is especially large when national output is below potential and unemployment is high, as in India.

A counter-cyclical movement in excise taxes, especially on fuel, can reduce this sacrifice. If taxes only rise when international oil prices fall, as happened in 2014 and in 2020, but do not fall when international oil prices rise, it will re-impose the earlier ratchet, causing cost creep, keeping Indian inflation higher than international, and making it difficult to anchor inflation expectations. World oil prices were lower in early 2021 than they were at end-2014. But Indian retail prices were higher. When households and firms expect oil prices to fall after they rise, they learn to look through them and there is less likelihood of second-round effects and a rise in inflation expectations.

International oil prices have been excessively volatile after the 2000 US Commodity Futures Modernization Act, which eased market-trading position limits, among other deregulations, aggravating market swings. Brent oil ranged from $132 in mid-2008 to $30 in January 2016, with sharp swings in between. A crash to $18 with covid did not last long. Post Ukraine, it again rose briefly above $130. The monthly coefficient of variation was 25 before the 2000s and 42 after. Such volatility hurts both importer and producer countries and needs to be taken up in international fora.

A formula to introduce some counter-cyclicality in oil taxes for states as well as the Centre, linked to thresholds in international prices, would reduce extreme volatility without reverting to the earlier ratchet that pushed up costs. It would help establish inflation targeting, reduce delays due to stand-offs between the Centre and states, and be a step towards the inclusion of fuel in India’s GST system. Governments would still have the power to change taxes on oil at will, but some part of oil taxes would automatically fall with a rise in global oil prices and rise when these prices fall. The changes would be distributed between the Centre and states.

Ashima Goyal is emeritus professor of economics in the Indira Gandhi Institute for Development Research