Macroeconomics of oil price during covid-19

The outbreak of Covid-19 led to a series of lockdowns, restrictions on the mobility of people along with travel ban that led to the decline of demand for oil. India being one of the major importers of crude oil with 60 percent of its total import bill constituting oil, a fall in the demand for oil may help not only in reducing import bill but also improving its balance of payments. If not for the long run, at least in the short term it brought respite for policymakers in tackling oil related problems. However, with recent cuts in the supply of oil from the Middle East countries on the one hand, and increasing demand for oil due to opening up of the economy on the other, oil price started to soar up again. On the Republic day, the petrol and diesel price in the national capital crossed Rs 86 and Rs 66 a liter respectively. This may be quite worrisome given the economic scenario we are trapped in. However, before exploring what we are up to, we first need to understand how oil prices rise and how they affect the economy.

Oil price, like any other commodity, is determined by the demand for, and supply of oil. An increase or decrease in oil price is mainly caused due to the mismatch of demand for and supply of oil. Oil prices thus can increase either due to supply cuts given its demand or due to increase in demand for the given supply. Since, both the ways prices increase but their impact on economy may vary. This can be explained as: an increase in oil price due to supply shortage increases domestic prices and depresses output growth through rise in input production costs. However, if oil price increase is due to increase in demand, it increases in the output growth rather than depressing it. This has well been documented in the literature especially in the works of James D. Hamilton and has been evidenced as well. The oil price shock of the 1970s that was driven by the supply shortages due to OPEC countries placing embargo on oil exports, not only sky rocketed oil prices but also led to a recessionary pressure in the economy. However, the case was entirely different during the period from 2003 to 2007. The oil price rise during this period was not an outcome of supply shortages but mainly driven by the booming global economy and it did not depress the economy. Thus, oil prices may not always be depressing for the economy.

However, in the present times when India’s growth trajectory is already sliding down, an increase in oil prices due to cuts in the supply of oil may lead to stagflation- a situation in which inflation rises along with fall in the output. This will be worrisome for policymakers because stabilization policies such as monetary and fiscal policies may not be of much help. This can be described as: If monetary policy increases its policy interest rate to control the inflationary pressure due to rise in oil prices, it may end up throwing the economy into disarray by not only drying up the market liquidity but also reducing investment and thus depressing output. An increase in the policy rate by the monetary authority in the current scenario will not only deepen the crisis but may also turn the recession into a full-fledged depression.  Moreover, an increase in the policy rates does not seem to be on cards for the Reserve Bank of India (RBI). The reason being that in a series of recent movies, the RBI reduced its policy interest rate to insert liquidity in the economy to fight Covid-19 challenges. Thus, monetary policy does not seem to be in a condition to combat the current oil price increase. However, the fiscal policy of the government that works through spending and taxes, may be helpful in reducing oil prices by cutting down the excise duty on oil prices. This, no doubt, seems to be an option for government to contain oil price increase but there are not only doubts but problems in implementing such a policy. In the present times, when government spending is the need of the hour, government is not going to cut down its own hands before fighting the war. Controlling oil prices by reducing excise duty will reduce government revenue, shrink their fiscal space and thus restricts them from using such a policy. At this juncture, it seems neither the monetary nor the fiscal policy may be used to contain oil prices and the brunt of this rise will be borne by the general public who are the final consumers of oil.

How is this going to play in an economy which is already depressed, is a matter of serious concern not only for policymakers but also for the general public who are suffering from it? With rising oil price, people either have to reduce their consumption of oil by shifting to other alternatives or they have to reduce their own consumption basket. Given that there are not much alternatives to oil, reducing oil consumption does not seem to be a viable option, at least in the short term. However, what seems viable is that people may reduce their consumption basket by spending more of their disposable income on oil and oil related products and less on other commodities. This may not only hamper their living standard but also reduce the aggregate demand of the economy. Thus, there seems to be more problems at hand than a viable solution. Reducing excise duty to contain oil price increase will shrink the already dry coffers of state at a time when need for fiscal stimulus to revive the aggregate demand is high. The government revenue needs to be properly and directly channelled (through cash transfers) to the poorer section of the population who are disproportionately affected by the pandemic and whose marginal propensity to consume is quite high. In these times, the government should focus on the welfare of the people rather than sticking to fiscal deficit numbers. At the same time, RBI needs to be more flexible on its inflation target and provide adequate and additional space for fiscal policy. Moreover, once the oil supply bottlenecks are removed and the aggregate demand is boosted, the economy will be on the path of recovery. What we need to understand is that it is not the game of numbers to be portrayed for a strong economy rather testing times where we all need to come out together.

Irfan Ahmad Shah is a PhD Student at Centre for Development Studies, Jawaharlal Nehru University.