Crude Oil is not the main factor of inflation

The noise and news of US banks crashing and the current outbreak of inflation have over shadowed the benefits of tumbling crude oil prices. First, let’s look at inflation. This is the main stumbling block for a benign monetary policy, which is a key driver for economic and corporate growth and which will eventually lead to better trends on the stock markets.

The present government’s key concern is the unabated advance of inflation, which it is trying to control with diverse measures. These include a hawkish monetary policy, increasing interest rates, and banning or curbing various commodity exports. Although such steps may bring a temporary reprieve, they will impact corporate sales and earnings, which is not good for stock markets.

Although the present inflationary trend is not encouraging, we see some respite in the overall inflationary trend, due to the sharp pull back in crude oil prices to below $100 a barrel. We see a strong correlation between crude and other components forming a major part of the inflation index, because the latter are either derivatives of oil or are impacted directly or indirectly by oil prices.

What is the genesis of the current malaise? When the dotcom bubble burst in 2001, it led to a benign interest rate regime worldwide, aimed at boosting economies that were slowing down. That’s what we consider the root cause of the inflation malady. Readily available and easily accessible funds for consumers encouraged acceleration consumption of products and services. World GDP, which had been cruising at about 3% for a decade up to that point was propelled to 5% over the next few years, thereby constraining the supply side. In tandem with this demand, prices of metals such as Steel, Copper, and Aluminium soared by 20% to 50%. When oil peaked at $147 per barrel, the price of crude has risen year-on-year by 103.5%. Our systems which are not geared for this kind of growth, succumbed to this higher demand, giving rise to inflationary pressure in subsequent years. Indian government was left with no option but to intervene.

Research suggests that the key component to be monitored and controlled is the price of crude oil. Consider the inflation figure of 12.1% for the week ending August 30, 2008 a multi-year high for India. Five hundred items are included in the Wholesale Price Index. If we consider only items with a weight-age of more than 1% where the rise in inflation topped 10% year-on-year that list shrinks to a mere twelve. Notably, these 12 items have contributed to 50% of inflation. Of these 12 key elements, eight are either derived from crude, or follow the prices of crude. Their prices have gone up with crude.

One may ask: how did the rise in crude oil prices impact the prices of edible oil and cotton? According to recent findings by the World Bank, the diversion of farm land to produce bio-fuels is the number one factor in food price inflation. This has led to inflation in most agricultural products, including wheat, rice, maize, and edible oil. The prices of these products have soared more than that of crude oil-possibly the result of the relatively inelastic demand for food.

Most developing countries give significant weight-age to food and agricultural products in their inflation index, which is why their inflation rates are around 10% or higher. So any increase in the production of bio-fuel at the cost of food production has a significant impact on the price of these commodities. So the answer to current inflationary pressure lies in crude oil. Fortunately, as oil prices have dropped substantially, and are likely to remain benign for quite some time, we will probably see inflation dropping to reasonable levels sooner than expected. This, in turn, will ease the liquidity situation and lower interest rates, making funds more readily available to consumers. Also at these reasonable rates, companies will be able to generate better sales and earnings. Obviously, better earnings mean a more robust stock market and higher stock prices.