DIPPING INTERNATIONAL OIL PRICE AND PERSISTING INFLATION

FOZIA ISHAQUE (fozia.ishaque@hotmail.com)
Jan 19 - 25, 2009

During the last six months there has been a drastic drop in the price of oil in the international market, which has fallen even more precipitously than it rose. In a year's time, a commodity that was theoretically priced according to supply and demand doubled from $69 a barrel to nearly $150, and then, in a period of just three months, crashed along with the stock market to less than $40. Oil price changes affected our economic activities such as growth, inflation, trade balance, and so on. According to the SBP's annual report global commodity prices indexes prepared by IMF indicate that food and fuel prices increased by 42.3% and 79.8%, respectively, during July-07 to Jun-08. This phenomenon left its impression on the economy of Pakistan also and inflation rose to over 20% during 2007-08. This increase in domestic inflation was exhibited by all price indices: annual average of CPI, WPI, SPI and GDP deflator. During 2007-08 the fiscal deficit climbed from 4.3% of GDP to 7.4% during 2007-08; the current account deficit accelerated from 4.8% for GDP to 8.4%; inflation (CPI) risen from 7.8% to 12% (WPI risen from 6.9% to 16% and SPI from 9.4% to 14.4%); the rupee depreciated heavily and the forex reserves depleted to an unsatisfactory level. These developments have adverse implications for the poor. The low income group has subjected to comparatively higher inflation of 10.71% during 2006-07 and 14.26% during 2007-08.

REASONS FOR INFLATION:

In spite of downward trend in oil prices the inflationary pressure is mounting in Pakistan as measured by all indicators. State Bank of Pakistan has missed the inflation target, citing the reasons as preference for crops used in bio-fuel production, higher food demand from emerging economies and low inventory levels of key food commodities along with higher fertilizer price. During first eight months of the year 2007-08 these reasons have been coupled with high fuel prices. An increase in oil prices such as that seen in the second half of 2008 causes an inward shift in short run aggregate supply and puts upward pressure on the price level in other words a sharp jump in the price of crude oil causes an exogenous inflationary shock and the impact will be greatest when a country is (a) a large-scale importer of oil and (b) has many industries that use oil as an essential input in the production process. Research suggests that a $3-4 rise in oil prices can be expected to add directly about 0.1% to consumer price inflation. Of greater impact are the knock-on effects of increased costs through the supply-chain. The second-round effects on inflation are more complicated, as businesses pass through higher costs. Analysis from economists at the Bank of England has estimated that a $1 rise in oil adds a further 0.1% to inflation after two years (including the petrol effect). A doubling in oil prices would have many other inflationary effects: increasing the cost of heating oil and aviation fuel, plastics, chemicals, as well as raising the material costs of all firms (which would likely be passed onto consumers).

While food inflation is primarily responsible for surge in CPI and SPI, acceleration in WPI is equally contributed by both food and non-food inflation. Upward adjustment in fuel prices were mainly attributed as responsible for deteriorated trade balance. However other factors such as unanticipated hike in global commodity prices, rationalization of wheat support price, pressure on flour due to speculative shortages and sharp depreciation of rupee have also triggered inflation. Govt. of Pakistan has been getting heavy profits by not reducing the oil price despite the Oil prices have dropped drastically world over because of economic.

SBP has reviewed and presented an overview of 2007-08 domestic inflation outlook. According to central bank report, the inflationary impact of recent hike in food prices is of particular concern for emerging and developing economies, as food price increases accounted for almost 70% of headline inflation in 2007. Apart from high food prices, sustained rise in the international crude oil prices has been a challenging development for price stability due to its direct and indirect implications for inflation. It has direct effects on headline CPI to the extent of its weighted contribution. Prices of wheat, rice, edible oil, corn, metals, DAP, urea, crude oil and gold have touched historic highs after July 2007. It is pertinent to mention that a sharp depreciation of rupee during this period also fueled inflationary expectations in the economy. The administrative policy actions include pass through of oil and energy prices to domestic consumers, while exogenous shocks comprise unprecedented rise in international crude oil prices and record high government borrowings from SBP to finance its burgeoning fiscal deficit, which pushed inflationary rate to high levels. It should be remembered that 15.4% expansion in money supply during FY08 is significantly lower than the growth in nominal GDP. It means that a substantial part of monetary overhang of earlier years had also been absorbed. The existence of price distortions and weak structure of supply chain management also contributed to the high grain prices. For instance, despite that the total available domestic wheat stocks were sufficient for domestic consumption, price of wheat increased sharply during FY08.

FUTURE OUTLOOK:

Oil prices, which rocketed to record highs above $150 a barrel in 2008 before plunging to $40, are likely to regain momentum in 2009 as commodity demand increases amid recession. The OPEC is keeping up its talk of production cuts and a cold snap in the United States boosted heating oil demand. The oil industry is scaling back on exploration and production because some projects don't make economic sense when energy prices are low. And crude oil is already harder to find because more nations that own oil companies are blocking outside access to their oil fields. Some analysts say oil could eventually eclipse $150 a barrel, maybe even on its way to $200.

Oil giants like Exxon Mobil, Chevron and Conoco Phillips have yet to announce their 2009 capital spending plans, but even the cash-rich companies are likely to shelve some projects. Already, Royal Dutch Shell has postponed a near-doubling of production in Canada's oil sands _ an operation that analysts say only makes economic sense when oil is about $20 a barrel more expensive than it is now. Marathon Oil says it expects to cut capital spending by 15% in 2009. In the wake of expectation and forecast of analysts for oil price to increase again it is imperative to take into consideration its probable impacts on our economy and counter the adverse effects proactively. It is wise to invent more energy-efficient plants and machinery, or changing consumer behavior, all of which would help us wean ourselves off oil.