Ripple effect of rising fuel prices: Get used to high food prices, RBI can do little to counter them

Raghuram Rajan remains worried about inflation. Despite repeated attempts, the RBI has had mixed success in taming prices

Like his predecessor, RBI governor Raghuram Rajan too remains worried about inflation. And despite repeated attempts, the RBI has had mixed success in taming prices.

Reserve Bank of India governor Raghuram Rajan has clearly decided to play spoilsport to the markets. By making it clear that he, like his predecessor, remains worried about inflation, he has also effectively signalled that with consumer prices at 9.5%, markets shouldn't expect those concerns to dissipate anytime soon.

As Rajan noted in his first policy meeting statement on Friday: "What is equally worrisome is that inflation at the retail level... has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency."

In recent years, the government move to liberalise fuel prices, and pass the impact of any increase in oil prices to consumers, has played a substantial role in keeping inflation high. The most visible impact on overall prices in recent months though, has come from vegetable prices, especially onions. Now, new research shows that the link between the two - fuel prices and food prices - is no coincidence.

A PERFECT STORM?

An increase in fuel prices has both obvious and more subtle impacts on inflation. One type of impact is straightforward - fuel prices (along with lighting) have a share of about a tenth in the overall basket of goods used by the government to calculate consumer inflation. So any increases in petrol or diesel or LPG prices will automatically result in the inflation rate inching higher.

But that's only part of the effect. Given that petrol or diesel is such a critical input into a range of sectors and industries, any increase in fuel prices will have a ripple effect, causing other sectors in turn to hike their prices. The trucking industry, for instance, when faced with paying more for diesel, will begin to charge higher transport rates from industry to move goods across the country. Industry will in turn attempt to pass on that increase in costs to their customers. And so on.

Take agriculture. Diesel is used by farmers to run their irrigation pumpsets, so any increase in diesel prices results in higher costs for farmers, and over a period of time, higher food prices for consumers. But again, that's only part of the effect.

GETTING WORSE

Because agriculture now accounts for a relatively small part of GDP, the impact of higher fuel prices on the sector has been relatively under-researched. But Anand says that such an impact is critical: a 10% increase in diesel prices directly raises agricultural costs by 0.56% (through the increased cost of running diesel irrigation pumps, for example).

This is a relatively weak effect. But take into account the impact of that fuel price hike on other industries which provide critical inputs into agriculture, and that 'total' impact is actually much higher - about 6.7 times the direct impact. Put differently, a 10% rise in fuel prices, and accounting for its economy-wide impacts, raises agricultural costs by 3.75%.

With the government looking to tame its subsidy bill by passing on rising fuel prices to the endconsumer, and with the use of inputs such as fertiliser in agriculture only rising, that impact is likely to get worse.

What does this imply for RBI policy on interest rates? The central bank can do little to tame such price increases on its own, since these result from policy decisions of the government. Instead by hiking interest rates, it has aimed in the past several years to tame demand in the economy, in the hope that this will help reduce inflation. So far that policy has had only mixed success. Whether Rajan will have any more luck in taming inflation than his predecessor remains to be seen. Meantime, consumers will likely have to live with higher prices for some time to come.
As Mukesh Anand, an economist with the National Institute of Public Finance and Policy in Delhi points out, apart from diesel the other big input into agriculture is fertiliser - an industry which is a heavy user of petroleum products such as naphtha.

Even though fertiliser prices are regulated, increases in the price of those fertilisers over the years by the government have a much greater impact on farmers today than they did a decade ago. That's because fertiliser use in agriculture has risen sharply. An average hectare of farmland in 1992 used up 69 kg of fertiliser.

By 2009-10, that had risen to 139 kg - almost double. And since the petro-products are a critical inputs into the fertiliser sector, this leaves agriculture (indirectly) highly exposed to fuel pricing policy. "The fossil fuel intensity of agriculture has been growing at a rapid pace," says Anand.

So what's the impact of such ripple effects on the economy? In 2011, the RBI, in a study, assessed that a 10% increase in domestic fuel prices could raise overall wholesale prices by about one percentage point in the short run. In the longer-run though, that 10% impact, would cause inflation to rise by about two percentage points.