Oil prices up, inflation down

Oil prices have gone through the roof this year. Yet inflation remains modest, and in recent weeks has decelerated. Year-on-year inflation was just 3.08% in the latest week for which data are available (ending August 20). This contrasts with 6.5% in the preceding year. So, inflation has halved although oil has gone from $ 45/barrel to $ 65/barrel this year.

This is puzzling and unprecedented. Earlier, sharp increases in oil prices in 1973-74, 1979-80 and 1990-91 sparked massive inflation, in India and abroad. Why not today?

In the USA too, inflation is moderate. Consumer prices are up 3%. Strip out food and fuel prices, which are notoriously volatile, and core inflation is only 2%. Markets are speculating that the Fed will end its anti-inflationary strategy of raising interest rates: why attack an enemy (inflation) already in retreat?

All commodities have shot up in price in the last two years, not just oil. Steel, non-ferrous metals, coal, chemicals and plastics have all shot up, though in some cases prices have fallen a bit from their peaks. Yet this widespread increase in raw material prices has not produced a big burst of global inflation. What accounts for this welcome but surprising change in the world economy?

First, globalisation has massively increased competition and innovation, putting downward pressure on prices. Just see how global manufacturing is shifting to China and services to India. Not only are wages much lower in China and India, productivity has also risen in leaps and bounds with the infusion of global technology and management techniques. In the USA, productivity has leaped up because of a high-tech surge driven in fair measure by immigrant technologists, another aspect of globalization.

Productivity was stagnant or falling in India during the old licence-permit raj: every rise in input cost was passed on to consumers. That is why earlier oil shocks caused high inflation. But when productivity goes up, manufacturers can hold or even cut their rates in the face of rising raw material prices. That is the new world we are living in today.

The price of computers has crashed from Rs 1 lakh in the 1980s to Rs 10,000 today, while the quality has risen tenfold. The price of telephone calls and mobile telephones has crashed as spectacularly. The cost of putting a camera in a mobile phone has dropped to $ 7.50, and may soon fall to $ 2.50. The price of all electronic items has crashed, from colour TVs and digital cameras to microwave ovens and DVD players. Global apparel prices have fallen relentlessly with outsourcing, and the abolition of textile quotas this year has meant a further 5-11% price cut.

Internal liberalization has been as important as globalization in India, with increased competition lowering prices. Although aviation fuel has quadrupled in price, newcomers like Kingfisher Airlines and Deccan Air have slashed air fares. Liberalisation of the old public sector monopoly in telephones was key to the fall in telecom rates. Financial liberalization has facilitated a crash in interest rates and easy consumer finance, greatly reducing the effective cost of owning a house or consumer durables.

Another major development has been the relentless shift in global GDP from manufacturing to services. The share of services in GDP rose globally from 57% in 1990 to 64% in 2000, and may be approaching 68% today. Even in Sub-Saharan Africa, the share of services in GDP crossed 53% in 2000.

Now, services are not material intensive, and so can have moderate prices even when raw material prices are skyrocketing. Entertainment, medical and educational services, media, and trade use relative little raw material. Airlines guzzle fuel, but even there fares have gone up very little or crashed (because of no-frills airlines).

In service-dominated economies like the USA, the main contributor to inflation is wages rather than material prices. But the outsourcing of low-tech jobs in manufacturing and services has kept US wages in check. And in high-tech industries, the sharp rise in productivity has enabled wages to rise without creating inflation. Intel regularly halves the price of computer chips despite rising wages.

What does this imply for the world? First, the world can accommodate big increases in oil prices without suffering a big burst of overall inflation. This in turn means that high oil prices are less likely to cause a recession than in the past. If overall prices are moderate, consumer demand will not collapse (and thus cause a recession) even if petrol costs a lot more.

Second, governments can run much higher fiscal deficits than before, and yet escape inflationary consequences. The USA and India are already proving this.

Third, low-income countries that can attract global outsourcing will fare very well, even if they have less than optimal policies.

On all three counts, this is excellent news for India. No wonder the Sensex is booming.

What do you think?