The Hindu Business Line : Oil, inflation and interest rates

If because of the government not `passing-through' the full impact of crude oil price hike, inflation is unrealistically measured, it has implications for the computation of the real interest rate. A. Vasudevan looks at these issues and thinks that generating a producer price index may better reflect the inflation and help policy-makers set interest rates.

THE RISING international crude oil price was rightly blamed by the Finance Minister, Mr P. Chidambaram, at a number of international forums as restraining growth and other developmental efforts of India and a number of other countries dependent on imported oil. The opinion in industrialised countries too has, in general, been critical of the increase in oil prices. In the US, this single development has been cited as the most significant downside risk to economic growth and an upside risk to inflation expectations.

The level at which crude prices have been ruling, not to speak of the rate of their increase, over the last 12 months, is shockingly high, notwithstanding some softness in the last couple of weeks at around $60 a barrel. The forecast is that prices would rule between $62 and $66 a barrel between now and February 2006.

The consequential rise in the prices of oil products in countries where prices are flexible and are passed on to consumers has affected the producer prices noticeably. As producer price movements often get reflected in consumer prices only with a lag, inflation expectations are running high. In the US, the current inflation expectations are seen as posing a downside risk to economic growth.

The high oil product prices all over the world are attributed to high demand, low refining capacities and some `speculative' pressure from oil traders. The demand is likely to be high because of the robust growth in most oil-consuming countries. The lead time for increasing refining capacities is estimated at about three years. Speculative pressures exist in markets that are characterised by excess demand but it could be somewhat mitigated by improving the organisation of markets.

India's policy preference not to pass on all the crude oil price increases to the ultimate consumer is dictated by political realities even if it means considerable fiscal burden. It does not, therefore, make sense to speculate, at least at this point in time, as to whether the pass-through should be done at one shot or in stages.

It is important to note that the oil price rise this time is not due to any shock as in the previous three occasions (the OPEC's decision to quadruple prices in 1974 or the conflict situations in West Asia in 1981 and 1990). One would, therefore, be tempted to consider the order of price increase this time to be of relatively permanent nature and movements in prices would be dictated mainly by demand and supply forces.

Many observers, however, believe that the adverse effects of the international oil price hike this time would not be as severe as in the earlier instances. In the 1970s and the early1990s, it may be recalled, the increases in the wholesale price index (WPI) touched double-digit levels mainly because of the oil price rise.

But these episodes of inflation were short-lived partly because they were succeeded by two factors — improved availabilities of domestic supplies of essential goods and a large accretion to international reserves, particularly due to a sharp rise in invisible earnings. Given the high growth prospects and the fairly large international reserves, it is believed that the present level of oil prices would only push up the cost of production. As the existing production capacities in the industrial sector are believed to be almost fully utilised, the higher costs would have to be endured. This means that producer prices should go up.

India does not generate producer price index (PPI), and the WPI is a poor approximation to the PPI. The cost increases in the manufacturing sector get recorded in the WPI only to the extent of the permitted `pass-through' which can well be interpreted as a variant of `administered pricing'. Even the limited rise in oil price-induced manufacturing goods inflation may not be wholly reflected in the consumer price index for industrial workers (CPI) as the consumption basket includes very few of the manufacturing items that are considered in the compilation of the WPI.

Monetary authorities in industrialised economies use the concept of core inflation (inflation minus the energy and food prices) to gauge the inflationary pressures and expectations, since in these countries the expenditure on food is relatively a small proportion of the average consumption expenditure and the pass-through of oil prices is full — the two aspects that are not valid in the case of India.

The concept of core inflation, therefore, has limited significance for India. One, therefore, would have to continue to use the unrealistic official series of WPI for measuring inflation. Constructing PPI with full pass-through could improve matters. Reorienting CPI with a more up-to-date consumption basket would be a better approximation to the PPI than the WPI. In the circumstances, it is worth examining whether market surveys of inflation expectations would help in policy making.

If inflation is unrealistically measured, the computation of real interest rate (nominal interest rates minus expected inflation) becomes that much more difficult. Nominal interest rates would then become important. They are supposed to reflect the extent of utilisation of production capacities and the WPI inflation rate plus the computed quantum of the disallowed pass-through of the oil price increase.

Where financial markets are not fully developed or where bond and new issuance markets are still developing, nominal rates are influenced essentially by the actions of commercial banks. The nominal loan rates of commercial banks in India are relatively high while the nominal deposit rates are low. The difference between the two rates has been consistently high over the last 35 years in spite of claims of severe competition among banks. The wedge has helped banks invest in new technologies, cover the losses incurred on their assets, take care of the high costs of operations, including wage bills, create required reserves and earn enough profits for distribution to the owners.

The returns on loans and fee-based services have been high compared to the returns on their investment portfolio. In the loan portfolio, again, the banks charge higher rates for non-prime borrowers since prime borrowers can mobilise resources from other avenues as well, including external borrowings. But the extent of lending to non-prime borrowers is limited by the bankers' perceptions of risks and by prudential regulations.

Depositors, in particular those who hold savings accounts, get very little compensation. Any possible consequence of disintermediation is taken care of by credit creation to generate deposits, typically as standard text books on banking say.

Two important implications can be drawn from the banks' behaviour. One is that it has facilitated the governments to successfully conduct their market borrowing programmes. Otherwise how does one explain the banks maintaining such high statutory liquidity ratios? Second, the policy-makers' intentions on the `level' of the interest rates and the banks' behaviour do not synchronise. Is it because of incomplete market development? Or, could it be the sticky wedge? Research in this area is needed if one were to dwell on the contemporaneous and prospective effects of interest rate setting on real variables.

(The author, former Executive Director of the Reserve Bank of India, could be reached at asurivasudevan@hotmail.com)

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