Select The Impact of Rising Commodity Prices The Impact of Rising Commodity Prices

09 Nov 2021

While the Indian economy has been recovering well from the ravages of the pandemic, the recent increase in commodity prices has emerged as a huge concern. Inflation was not expected to rise at this point, given that demand is still subdued as a result of the hit to incomes inflicted by the pandemic.

Typically, inflation rises when capacity creation fails to keep pace with the surge in demand. That is certainly not the case in India where consumption demand, though rising, remains muted, especially among households that have suffered income losses. As a result, capacity utilisation levels for most industries are well below 100%. Only a few sectors, such as metals and cement, are investing in additional capacity.

However, a boom in the global price of commodities, driven by large fiscal and monetary stimulus by major global economies has driven up the cost of inputs in the manufacturing sector. Such inflationary episodes usually do not last for long unless they are sustained by continuous supply-side shocks.

The current episode, however, has been continuing for some time due to multiple factors. For one, oil prices have remained high as countries ease their pandemic-related travel restrictions while OPEC+ countries have not increased supply. A shortage of coal due to weather related factors has led to price increases and power shortages in countries where energy supply is largely dependent on coal.

Bloomberg Commodity Index

Meanwhile, supply chains have been disrupted globally as pandemic-related protocols have led to congestion at ports and higher shipping costs. News of container shortages continue to headline, along with the scarcity of semi-conductors. As a result of such supply-side issues, the WTO expects the growth in global trade volume to moderate from 10.8% in 2021 to 4.7% in 2022.

In India, inflation has been moderating, as per Consumer Price Index (CPI). This is largely due to moderation in food prices, which has a large weight in the CPI basket. Core inflation, that is inflation stripped of food and fuel prices, is still high at around 6% for the last several months.

The RBI has been rightly maintaining an accommodative monetary policy stance, given that inflation is being driven by pandemic-related supply shortages. Monetary support would be required till such time as the economy is fully recovered. In any case, the RBI has an inflation target band of 4-6% and the September inflation print at 4.3% is well within it.

Consumer Price inflation (% y-o-y)

In fact, inflation has been much higher in the US at over 5% over the last few months. The Federal Reserve in its commentary has considered this to be ‘transitory’ and expects inflation to moderate as supply chain disruptions fade away. Despite expectations that it will begin to ‘taper’ its asset purchase programme of $120 billion per month, it is yet to do so. The chief consideration for the Fed is to get the economy back to full employment, so that people who were laid off during the pandemic can get back to work. The RBI too is leaning in favour of maintaining its bond buying programming and managing liquidity so that there is enough support to the process of economic recovery.

For industry, a rise in interest rates would simply add to cost factors at a time when input costs are already rising. Businesses may not be able to pass on the cost increase to the customer, given that demand is still muted across most sectors. For small firms that have limited pricing power, it is especially difficult to manage rising costs along with hurdles in logistics. For households, while the mounting fuel costs have had a huge financial impact, the recent reduction in taxes on petrol and diesel has been welcomed by many.

As the economy takes slow steps towards recovery, policy makers need to wait and watch before withdrawing any stimulus.

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