High oil prices decks GDP

With rising gas prices now rivaling unemployment as a key issue in this year’s election, both the president and his Republican opponents have been speaking out about what, if anything, should be done. Republicans argue that the nation needs more domestic oil and gas production while the president notes that oil is produced and sold on world markets, meaning that domestic supplies have a small impact on prices. That said, rising gas prices do affect both consumers and the economy adversely, and they are especially harmful to lower- and moderate-income households.

One assumption is that these households do not all own cars, that many use mass transit instead. Looking at all households with annual incomes less than $50,000, it turns out that the vast majority (80%) do own cars, and a significant portion (over a third) own more than one car. Of course, even if they do not own cars, higher gas prices can affect mass transit riders as well once higher costs show up at the fare box, although this undoubtedly occurs with more of a lag.

Among low-to-moderate-income households that do own cars, they drove about 10,000 miles and spent about $1,500 on motor fuel during 2010 when the average price of gasoline was about $2.80. Gas prices are now approaching $3.80 a gallon, and some observers believe they could reach $5.00 by this summer. Every dollar increase, holding the number of miles driven constant, would cost these moderate- and lower-income households an extra $530 per year. For a family with an annual income of $20,000, this is an additional 2.7% of their total income. Although higher gas prices eventually encourage consumers to cut back on driving or switch to more fuel-efficient vehicles, in the short-run they may have few options but to cut back on other expenditures in the family budget. Since low- and moderate-income families’ spend most of their income on average, in the very short run they can only choose between spending less on other items and going further into debt. In addition, less spending on other items operates much like higher taxes in slowing an incipient recovery. In other words, higher gas prices drain purchasing power from the economy. That means that these families get hit twice: once by the direct impact on their household budgets but a second time when higher prices retard the economic recovery. In  in the  on the contribution of oil price shocks to past U.S. recessions, James D. Hamilton finds that they slowed GDP growth significantly, often enough to tip the economy into a recession. Goldman Sachs estimates that just the oil price increase since December will shave between a quarter and a half of a percentage point off of real GDP growth over the next year, and the effects could be more dire if oil prices continue to rise.

To be sure, in the longer term, consumers will adjust how much they drive and how much they spend on gas in response to higher prices at the pump. Research suggests that in the short term — less than a year — the so-called price elasticity of demand for gas is about -0.25, meaning that if the price of gas goes up 10%, consumers will demand 2.5% less gas. In the long term, the elasticity is closer to -0.6. If we apply these numbers to the gas expenditure figures above, I estimate that a $1.00 increase in the price of gas will result in low- and moderate-income families spending about $350 more on gas in the short term. These estimates represent an average for all low- and moderate-income families. Certain households, such as those living in rural areas without access to public transportation and thus no way to get out of their cars, will be hit even harder.

Rising gas prices produce a level of hardship for a group that is already suffering from high levels of unemployment and stagnant or declining real wages. Even in good times, but especially in recessions, the least skilled are far more likely to be unemployed. In January 2012, the unemployment rate was 4.2% for those with a college degree, 8.4% for those with only a high school degree and a staggering 13.1% for high school dropouts. Similarly,  by the National Employment Law Project found that since the start of the recession, while workers in higher-wage occupations saw 0.9% real wage growth, mid-wage workers’ wages fell by 0.9% and low-wage workers experienced a 2.3% decline in real wages.

Most experts do not believe there is much that government can do to reduce oil price spikes caused by unrest in the Middle East or other short-term factors. But the government can at least cushion such effects by providing unemployment insurance benefits, payroll tax cuts or other assistance to lower-income households to help offset the impact of higher gas prices on both their pocketbooks and the strength of the economic recovery.

Oil prices have always haunted the Indian economy. An adverse oil price shock tends to mess up many of India’s macroeconomic variables. Since the Russian invasion of Ukraine, oil prices have started moving to uncomfortable zones. Over the last year, Brent crude price has doubled. Even in March, there has been huge volatility in oil prices. There is speculation that if the war does not deescalate, oil prices may soon touch $140 a barrel.

Faced with such a steep upward movement of oil prices, policymakers have perhaps gone back to the drawing board to evaluate its impact — that too when the economy has just started coming out of the pandemic.

What were the oil price assumptions at the beginning of the year? In its January 2022 update of World Economic Outlook, the IMF assumed oil prices to be $77.31 in 2022 and $71.29 in 2023. In India, a key assumption behind the projected GDP growth in the Economic Survey 2021-22 has been that oil prices would be $70-75/barrel. With all such assumptions going haywire, where is the Indian economy headed to?

The most obvious impact of high oil prices in India is on domestic inflation. Domestic oil prices are going up. There has been a steep hike of ₹25/litre in bulk diesel prices, and petrol, diesel and LPG prices are steadily moving up. This will have a direct impact on inflation. ‘Fuel and power’ have 13.20 per cent weightage in the Wholesale Price Index (WPI), and ‘fuel and light’ have 6.8 per cent in the Consumer Price Index (CPI).

Cascading effect

Moreover, fuel and energy prices have a cascading effect on prices as they push up costs at every stage of production. Recent unofficial estimates suggest that in an optimistic scenario of international oil prices at $100/barrel, domestic inflation is likely to go up by 52-65 basis points (bps). In October 2021, the RBI estimated that a 10 per cent increase in crude oil prices might push up domestic inflation by 30 bps.

Moreover, this increase in oil prices comes in the backdrop of already high inflation rates. While CPI inflation in February stood at 6.07 per cent, WPI inflation was at a much higher 13.11 per cent. The divergence between CPI and WPI inflation is possibly an indicator that CPI inflation is on its way up in the coming months.

To control the rising inflation, the government can absorb some of the increase in international crude prices by reducing taxes on petrol and diesel. But this can have a negative impact on tax collection. The Russia-Ukraine war and the increase in gas prices have also pushed up the domestic prices of urea and potash. This threatens to increase the fertiliser subsidy bill of the government by about ₹10,000 crore. The government will have to rework its budget to accommodate these cost escalations.

The increase in oil prices and the recent geopolitical turmoil are also likely to hurt India’s GDP growth. Recent estimates have revised India’s growth rate for 2021-22 and 2022-23 downwards. For example, a leading investment bank recently revised India’s growth rate to 7.9 per cent for 2022-23 (down by 50 bps), while a leading rating agency has reduced the growth forecast to 8.5 per cent from 10.3 per cent for the same period. Reduction in growth and increase in oil bills can lead to demand compression in the economy, which can also affect the government’s revenue collection for the fiscal 2022-23.

Balance of payments

The impact of the oil price rise can also be severe on India’s balance of payments. Crude oil approximately accounts for about 20 per cent of India’s total imports. Due to the inelastic nature of its demand, an increase in crude prices invariably leads to higher import bills for the country in the short run. This worsens the current account deficit.

This time the problem is more acute as India is witnessing one of the most significant outflows of FII money over the last few months. A combination of high oil prices, ongoing geopolitical disturbances, outflow of FII money and the looming threat of Fed rate hike makes it an extremely challenging task for policymakers. This also has implications for the exchange rate. Of course, thanks to the prudent policies and forex management strategy, the rupee did not experience any abnormal pressures so far.

How do we see the immediate future? A doomsday prediction is ruled out but oil prices are likely to remain volatile in the near future. Supply-side factors like the course of the war, global sanctions, and the decision of the OPEC to regulate the production of oil will be important.

Tackling oil price shocks

But from the demand side, there are a few factors that could moderate the oil price rise. Global growth may slow down, and growth projections for China are also being revised downwards. As China is the world’s second-biggest consumer of oil, any major demand reduction from China will also have a net negative impact on oil prices.

Notwithstanding such elements of uncertainty, rising oil prices can be the ultimate spoiler of the insipient Indian economic recovery. The government may consider measures to cope with future oil price shocks. While diplomacy and long-term contracts with some major oil producers can help ensure India’s energy security, strengthening and boosting India’s strategic oil reserves could also be explored.

Admittedly, the choices are complex and at the current juncture, the oil price situation is perhaps characterised by what is known these days as VUCA (volatile, uncertain, complex and ambiguous). It remains to be seen how much of the VUCA elements get transmitted to the Indian economy.