Oil shock: What the RBI can do

After the early 1980s, the real oil price has become quite cyclical. It goes up and down with a very slight long-term upward trend. So, if the international oil price goes up, ideally the government should reduce the tax on oil or even give a subsidy so that the domestic price of oil does not go up much. And, subsequently when the real international oil price is quite low, the government can impose a large tax. Again the domestic oil price remains somewhat stable. However, the government may not do all this.

Then the question is, what can the Reserve Bank of India (RBI) do? Precious little, many would say. This is not true. But before I come to the alternative policy proposed here, it will help to first review the basic prevailing policy.

Over time, the RBI increases the reserve money in line with the rise in GDP and the targeted inflation; the response of the RBI can, of course, vary from year to year. But when we have an oil price shock, this factor tends to push up the general price level more. This, in turn, raises the demand for money to an even higher level. Under the prevailing policy, this additional demand for money is also met by the RBI. This is what sustains the higher general inflation. This is where the RBI plays a role in what is supposedly cost-push inflation linked to oil price hike. After a while, there can be a spiral and the inflation rate can get even higher.

From July 10, 2020, to May 20, 2022, the reserve money has increased in India at an annualised rate of 15.37 per cent. The consumer price index has now risen by 7.8 per cent year-on-year. So, the high inflation in the economy is not entirely due to the oil price hike and the other supply side factors.

On May 4, the RBI started reversing its expansionary policy. It hiked the repo rate by 0.4 per cent. On June 8, the RBI increased the repo rate by another 0.5 per cent. There are likely to be more rate hikes as we go forward. In the process, the economy will very likely slow down significantly, though the RBI is presenting a different view.

Another obvious but important point relates to the distinction between absolute prices and relative prices. The absolute oil price rises at a very high rate and the absolute prices of other goods and services rise somewhat at their usual rates. This is how the rise in the price of oil relative to other prices and relative to incomes takes effect.

Let us now come to the alternative policy framework proposed here. Broadly speaking, as the oil price rises, even though there is a push in the prices in general and the demand for money rises, the RBI should not increase the reserve money substantially. This makes the so-called cost-push inflation linked to oil price hike unsustainable at a high rate. Now it is true that the higher relative price of oil is inescapable. But this can still happen with a smaller rise in the absolute price of oil, and a much smaller, even negligible, rise in the absolute level of very many other prices. So we can still get the same given rise in the relative price of oil.

It is true that the above adjustments cannot happen if the targeted inflation rate is low, let alone zero. But this is not the case in India. The RBI has the mandate to target 4 per cent inflation with a leeway to let it rise up to 6 per cent for a while. So, there is scope for adopting the proposed policy — more so, when the jump in oil price does not happen in one go. Of course, due to the oil price hike, the economy will go through some pain and slow down.

Let us now compare the prevailing policy and the proposed policy. We have a slowdown in the economy in either case due to adjustment costs and larger payments for oil. Under the proposed policy, the slowdown happens “on the way”. Under the prevailing policy, the slowdown begins after the general inflation hits a high rate. That is when the slowdown cannot be deferred anymore. So, for many observers to say at this stage that we control inflation at the cost of good economic growth is a bit misleading. The fall in economic growth was waiting to happen!

Though the higher relative price of oil and the related economic slowdown are unavoidable under either of the two policies, the absolute price level rises less under the proposed policy than it does under the prevailing policy. So, the proposed policy is superior to the prevailing policy.

The writer is visiting faculty at the Indian Statistical Institute, Delhi Centre