Get out of the oligarchy: Why RBI shouldn’t worry about short-term inflation
There could be a fundamental inconsistency in this scenario. Under normal circumstances, oil and commodity prices go hand in hand with growth, as growth increases the demand for commodities and pushes up their prices. There is a clear causality running from growth to oil prices. However, this causality disappears if prices rise following a major supply disruption – war and economic sanctions being a classic example – which affects either production or market availability.
Generally speaking, in this case, the causality runs from supply to demand and to growth. Over the past five decades, oil shocks have almost always been followed by a slowdown in global growth. A simple sensitivity calculation shows that global growth could be 1% lower if oil prices remain at current levels in 2022.
There is a twist in this story. As global growth falls, so does the demand for energy and industrial inputs. Eventually, their prices adjust downward to reach an equilibrium. Thus, extremely high commodity prices in the short term trigger a process that lowers them in the medium term.
Prior to the onset of the Ukraine crisis, HDFC Bank’s supply and demand analysis pegged the equilibrium price which equated demand to supply at $70-75 per barrel of oil (brent crude) . Global oil demand was projected at 100.6 million bpd – up nearly 3 million bpd from 2021 – and supply at 101.4 million bpd, leaving a marginal surplus in the market of around 0.8 million bpd by the end of the year. This corresponded to global GDP growth of 4.4% for 2022 with the United States at 4%, China at 4.8% and Europe at 3.9%.
The difference between the actual price of around $85 a barrel before the rise of geopolitical tensions and the fair price was partly a risk premium (taking into account the potential uncertainty of oil supply) or simply a premium of the financial market caused by liquidity. Like stocks, oil is also a traded financial asset. And just as excess liquidity adds scum to stock market valuations, oil prices are trading above fair value due to liquidity conditions.
What happens to this balance with the war in Ukraine? In an extreme scenario, where Russian oil disappears from the market entirely and global demand remains the same, the fair price rises to $100-110 per barrel. However, this is unlikely to be the case. The effort to harm Russia as much as possible while harming their own consumers as little as possible, a position that most Western leaders have taken, means that Russian oil and gas will at least partly be available on world markets. . Payment for this oil would circumvent the embargo on payments to Russia with an “exclusion” for oil and gas payments. Economies like China and India that have taken a neutral stance are not stigmatized when buying oil and other raw materials from Russia.
A tale in two halves
Meanwhile, additional oil supplies from OPEC and some non-OPEC oil producers this year could also help ease current tensions. OPEC may currently not meet its production commitments, but is expected to increase supply during the year. Add to that the growing possibility that nearly 1.3 million bpd of Iranian oil will hit the market if US sanctions are lifted, and the release of US strategic reserves – albeit small compared to all things – might help ease the pressures.
The demand side of the oil equation will also change. The current rise in oil and other commodity prices that is expected to persist for some time could dampen global growth impulses and dampen demand for energy and commodities through the “feedback loop” . Once this deceleration is taken into account, the calculations show a fair value of 80 to 85 dollars per barrel. If we add the average premium that adds to the fair value, the price should be around $90-95 per barrel.
The most likely scenario is that of a “two-part story”. Although in the short term pressure on commodity prices may increase, they should ease as global growth suffers. Thereafter, fear of inflation should also subside, prompting central banks to slow the pace of exit from accommodative monetary policy.
Without a doubt, short-term inflation prints should be ugly. But the strategy of making policy “data driven” should not force central banks to overreact. Monetary policy acts with long and uncertain lags and knee-jerk reactions to high inflation, encouraged by the media, could exacerbate the long-term slowdown. The bet is that central banks, if not markets, will have the foresight not to worry and trust the wisdom of the saying, “What goes up must always come down.”