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Economic Survey 2014-15

1.3 INFLATION AND MONEY

Structural shifts in the inflationary process
are underway caused by lower oil prices and
deceleration in agriculture prices and wages.
These are simultaneously being reflected in
dramatically improved household inflation
expectations. The economy is likely to overperform on the RBIs inflation target by
about 0.5-1.0 percentage point, opening up
the space for further monetary policy easing.
As elaborated in the Mid-Year Economic
Analysis 2014-15, the evolution in inflation has
surprised market participants and policy makers,
including the RBI. The momentum, measured as
the three month average seasonally adjusted and
annualized, has declined from nearly 15 percent
to below 5 percent (Figure 1.5).5 Interestingly, the
momentum of food prices has declined even more
and is at levels below overall inflation.
Going forward, this momentum is likely to persist
because of three striking developments in three
areas that signal a structural shift in the inflationary
process in India: crude-oil, agriculture, and
inflation expectations.
Crude-oil prices are expected to remain benign in
the coming months. Indeed, the average of
estimates by the IMF for (crude spot) and by the
US Energy Information Administration (EIA) for
Brent and West Texas Intermediate crude indicates
that oil prices will be about 29 percent lower in
2015-16 compared with 2014-15 (US$ 59 versus
US$ 82) (Figure 1.6).
The risk that the decline in oil prices will reverse
itself always exists because of unpredictable geopolitical developments. However, the persistence
of moderated oil prices seems highly probable for
at least three reasons: weaker global demand,
increased supplies, and the global monetary and
liquidity environment.

Demand will remain soft because of slow growth

in major areas of the world economy, including
China and Europe. Supply shifts are occurring
related to the increase in crude-oil and shale gas
production in the US and the concomitant decline
in the oligopolistic power of OPEC, notably its
swing producer, Saudi Arabia (which decided not
to react to the increase in supply from other
sources). Going forward, prices could increasingly
be determined by the marginal cost of shale
production estimated at around US$ 60-65 per
barrel.6
Finally, the anticipated end to the abnormally low
interest cycle in the US and the prospect of future
rate increases will favour extraction of oil over
keeping it in the ground, thereby further boosting
supply and keeping prices soft. Higher rates will
also lead to financial asset-reallocation away from
commodities, especially oil, as a class into US
financial instruments.
One lesson of the 2000s is instructive. This decade
witnessed an across-the-board increase in
commodity prices partly on account of excess
liquidity, created by synchronized monetary policy
easing in the advanced countries. That
synchronization has been broken by the diverging
macro-economic paths of the United States, where
recovery will lead to a reversion to normal monetary
policy, on the one hand, and Europe and Japan,
on the other, where policies may remain loose. Of
course, if China starts slowing and responds
through a combination of cheaper credit and a
depreciating exchange rate, global liquidity could
surge again but the US will still be in tightening
mode.
Second, in addition to oil prices, Indias inflation
will be shaped by pressures from agriculture,
foreign and domestic. According to World Bank
projections, global agricultural prices will remain
muted- a likely decline of 4.8 percent in 2015

Figure 1.5 is based on the new, re-based (from 2010 to 2012) CPI index.

Arezki, R & Olivier Blanchard, The 2014 oil price slump: Seven key questions, January 2015 accessed at
http://www.voxeu.org/article/2014-oil-price-slump-seven-key-questions.