The research objective of the thesis is to study the impact of International Oil Prices on inflation. The research is an initiative to find out the impact of International oil price on our domestic inflation. The paper mentions that among other factors productivity shocks, external shocks, and currency devaluation are major shock absorbers. The inflationary pressures are more sensitive to the productivity shocks than the impact of monetary policy operations in the short run and therefore, supply side measures along with monetary policy operations are important to control inflationary stance. The acquisition of internal growth momentum is emphasized to absorb the severity of imported inflation in the global economy as well as in Pakistan's economic scenario.
Empirical research has generated evolving impressions about the magnitude of oil-price effects on aggregate economic activity and about the extent to which activity responds symmetrically to oil-price changes. The empirical evidence presented in Hamilton (1983), based on linear VAR models suggested that exogenous shocks to oil prices had significant effects on real economic activity in the United States.
Many economists believe that monetary policy is responsible for generating the observed negative correlation between oil prices and economic activity, and may have played a role in contributing to the apparent instability of the correlation over time.
Bernanke (1997) provided analysis suggesting that monetary policy has been the primary reason that oil price increases have had negative output effects in the United States. Needless to say, the rationale for monetary policy responses to exogenous increases in oil prices is to contain the effects on inflation.
According to the nonlinear relationship between oil-price movements and output as outlined in Hamilton (2000), the sharp rise in oil prices over the last few years could lead to a decline in real output growth.
Hooker (1999) suggests that, in the United States since 1981, oil price shocks have only affected headline inflation, with no impact on core inflation. Does this result suggest that monetary policy no longer needs to respond to oil price innovations?
1.1 Energy Consumption Patterns
OECD member countries, for the most part, have the world's most established energy infrastructures. They are reported to have the largest share of current world energy consumption. This situation is expected to change over the time, with the rapid growth in energy demand in emerging non-OECD economies. In 2006, 51 percent of world energy consumption was in the OECD economies; but in 2010 their share falls to 49% percent. (International Energy Outlook 2009-World Energy Demand and Economic Outlook)
China and India are the two biggest non-OECD regions with the highest consumption of oil. China's oil consumption is expected to grow at a rate of 7.5% per year and India's at 5.5% per year. (International Energy Outlook 2009-World Energy Demand and Economic Outlook)
1.2 Inflation in Pakistan
According to Khaleeq Kiani (2007) higher oil prices directly raise consumer prices via the higher price of imported goods and petroleum products in the consumption basket. This chain of changes is called the cost-push inflation.
In Pakistan inflation is calculated on the three indices; CPI basket which contains 374 consumers' good; WPI basket which contains 425 commodities and SPI with 53 commodities.
Moreover, the rising trend in international commodity prices, particularly crude oil, metals and food items is likely to fuel-up inflationary pressures in the economy. (The state of Pakistan's economy, 2009)
2.0 RESEARCH HYPOTHESIS
The reason to conduct this research was to study and understand the correlation between the International oil prices that contributes towards Inflation. The oil prices are a major component of developing industrialized countries, an increase in oil price results in increasing finished goods prices. With the ever increasing commodity prices and decreasing economic growth, the need of studying the relation between International oil prices and our country's inflation rate
The hypothesis for this research is as follows: -
H1: To identify the relationship between the international oil prices (independent) and the inflation (dependent).
3.0 LITERATURE REVIEW
It has long been debated that effect of rising oil prices leads to the rising costs of inflation, imported bills, rise in production, transportation and all other energy costs.
Hamilton (2004) explained the several other internal and external factors which can be attributed to the inflationary rise. Major factors can be: sharp economic recovery bringing in rise in the levels of economy with a significant flow in domestic demand; with the continual effect of international oil prices and a spontaneous effect of commodity price increase. (Hamilton 2004).
Mork (1989) extended the work of Hamilton (1983), allowing oil price shocks to have asymmetric effects and inferring that oil price increases reduces real output while oil price declines had no effect.
Shiu-Sheng Chen, (2008) linked the macroeconomic variables to oil price shocks and concluded that output growth have a larger and longer-lived effect, the aggregate price level, and inventory investment. Economies are affected adversely due to ever increasing international oil prices. The most affected countries are the ones which are highly inclined and dependent on energy. Because they are exposed to a chain of processes linked to oil.
3.1 The Transmission of Oil Price Shocks
An oil price increase can influence macroeconomic behavior through several channels. Five of these seem particularly relevant in the first few years following the shock. First, the transfer of income from oil-importing countries to oil-exporting countries is expected to reduce global demand as demand in the oil-importing countries is likely to decline more than it will rise in the oil-exporting countries. This reflects an assumption that the propensity to spend in the oil-exporting countries is likely to be significantly smaller in the short run than in the oil-consuming countries. Second, the increase in the cost of inputs to production can reduce the amount of non-oil (potential) output that can be profitably supplied in the short run, given the existing capital stock and assuming that wages are relatively inflexible in the short run. Third, workers and producers may resist declines in their real wages and profit margins, putting upward pressure on unit labour costs and the prices of finished goods and services. Fourth, the impact of higher energy prices on headline price indexes (e.g., consumer price levels) and the potential for pass-through into core inflation may induce central banks to tighten monetary policy. And fifth, to the extent that policy reactions seem inconsistent with announced policy objectives, the credibility of the monetary authorities may be eroded, with consequences for inflation expectations and the inflation process. (Benjamin Hunt, Peter Isard and Douglas Laxton, 2002)
3.2 Impact and Flow of Rising Prices
With the increasing price war, the cost is ultimately transferred on to the next channel. For e.g. an increase in transportation costs and energy intensive industry products like metal commodities. Producers tend to impart the increased costs to consumers. The general domestic prices also rise in response to increase in international oil prices. Hamilton (2005)
Juthathip Jongwanich, 2009 and Donghyun Park, 2009 referred to the increasing oil prices affect on the economy from two different channels; the demand side and supply side. Surging global demand and the failure of global supply to keep pace has generated persistent upward price pressures.
Supply side is affected because of the high oil demand resulting in increased production costs. Given a swap in production factors comparative price changes results in reallocation of means of production.
Juthathip and Dongyhun further elaborated their research, differentiating between cost-push and demand-pull drivers of inflation. The central cost-push factors are international oil and food prices, while the main demand-pull factors are surplus aggregate demand, accompanied by the output gap, and inflationary anticipations, which are a function of delayed inflation. Whether inflation is the cost-push or demand-pull, it has reflective proposition for monetary policy. If inflation is driven by the rising input costs (cost-push inflation) of goods and services - a noticeable slowdown and increasing unemployment is likely to go together with higher inflation. Tightening monetary policy would come at an abrupt cost in terms of slower growth and higher unemployment. Temporarily, loosening monetary policy in return to declining global oil and food prices would not be important in pushing up employment and boosting economic growth. On the contrary, monetary policy would be more effective in controlling inflation if inflation was the demand-pull. In this case, tightening (loosening) monetary policy would dampen (boost) aggregate demand (Juthathip Jongwanich, Donghyun Park, 2009).
External cost-push factors especially oil prices appear to be more important in explaining producer price inflation than consumer price inflation. Oil prices are equally important in producer price inflation. In PRC; India; Philippines and Thailand inflationary expectations, measured by the delayed producer price inflation, explains much of the producer price inflation variance. They account for more than 50% in the Philippines and Thailand and around 45% for the PRC and India. Oil prices are more significant than food prices in explaining the variation in consumer price inflation. About 20% of the variation in consumer prices is explained by oil prices (Juthathip Jongwanich, Donghyun Park, 2009).
Schneider, 2008 distinguished his study by analyzing the prospect of real investment impact that it is fundamentally on the prospect of the stability of oil prices changes, which in case of international oil prices tend to change over time. Looking over the demand outlook the general level of prices drive up as a result of oil price shock resulting in a lower disposable income and reduced demand. (Schneider, 2008).
Juthathip (2009) and Donghyun Park, (2009) argues that during period of high fuel and food prices, currency appreciation limits the move across of these prices into domestic prices. In view of the reality that the global financial crises are intensifying, regional currencies in developing countries have generally depreciated
3.3 Inflation Trends
Juthathip (2009), further elaborated saying it is important to take a quick look at actual trends in the region's inflation over the last few years. Furthermore, the popular belief that region's inflation is driven by external commodity price shocks; it is also important to examine the recent trends in global food and fuel prices. No doubt the exchange rate movements are worth considering the extent of the pass-through of dollar-denominated global commodity prices into domestic prices determines the impact of shock.
Easy monetary policy can erode the anti-inflationary credibility of monetary authorities and, thus, contribute to the formation of higher inflationary expectations. (Juthathip Jongwanich, Donghyun Park, 2009).
Oil prices directly affect the general price level, resulting in higher wage pressures and lower demand dampens employment. We say our economy is hit by the change in international environment due to increased oil prices. Economic growth has thus replaced inflation as the main macroeconomic apprehension for policymakers.
Conversely, monetary policy could play an important role when inflationary expectations are taken into account, in holding inflationary pressure or in defusing deflation, despite the source of the shock. Monetary policy's effectiveness would be more imperfect if the sources of inflation are primarily external cost-push factors rather than demand-pull factors which can also cause inflation expectations. In this ongoing global slackening, the central banks of both developed and developing countries are loosening monetary policy to boost domestic demand, and also to smooth out the risk of deflation. In short, breakdown of inflation into its sources would help monetary authorities to spot appropriate monetary policy responses.
In Pakistan, excess aggregate demand and inflationary expectations are more important, this has reflective implications for monetary policy for the country. Particularly, it means that monetary tightening will continue to be a controlling tool for fighting inflation in the future. Higher interest rates can exercise their usual anti-inflationary effect by bringing down demand. Pre-emptive and decisive tightening of monetary policy can strengthen the case for firmly securing inflationary expectations for the country. Though, implementing monetary policy is inherently complicated and forward-looking in nature (Juthathip Jongwanich, Donghyun Park, 2009).
3.4 Resource Reallocations
Goodwin (2007) claims that increasing oil prices lead to reallocation of resources from energy intensive to energy-efficient sectors. This reallocation advancement is slow, resulting in short-term decline in output results which increases the economic slowdown. When oil prices reduce, the resultant expansion of aggregate output is dampened by adjustment costs. In this association, the adjustment costs impact is important on the labor market.
Óscar (2007), Jose (2007), Christopher, 2007 supports Goodwins claims and further analyses saying, in such a situation when output is slowed and prices rise employees will try to negotiate their wage hikes to compensate the loss of purchasing power. Oil shocks are the classic supply shock in traditional macroeconomic models. Labor becomes expensive in all sectors as workers try to adjust their inflation prospect. Margins fall throughout the economy, and cumulative supply contracts, pushing prices upward.
Oil prices in terms of domestic currency highlight the fact that world shocks because of exchange rate fluctuations adds up to the impact of domestic inflation, if proper monetary controls are not in place. The rising trend in international commodity prices, particularly crude oil, metals and some food items (e.g., rice and sugar) is likely to fuel inflationary pressures in the economy. (The state of Pakistan's economy, 2009)
3.5 Energy Consumption Patterns
In the International Energy outlook (2009) survey, OECD member countries, for the most part, have the world's most established energy infrastructures. They are reported to have the largest share of current world energy consumption.
This situation is expected to change over the time, with the rapid growth in energy demand in emerging non-OECD economies. In 2006, 51 percent of world energy consumption was in the OECD economies; but in 2010 their share falls to 49% percent. China and India are the two biggest non-OECD regions with the highest consumption of oil. China's oil consumption is expected to grow at a rate of 7.5% per year and India's at 5.5% per year. This compares to a 1% growth for the industrialized countries. (International Energy Outlook 2009-World Energy Demand and Economic Outlook)
54 of the 65 largest oil-producing countries have also reached and passed their peak in oil production. Global oil production is predicted to show signs typical of individual countries, and regions, with post-peak oil production declining at a rate driven by both supply and consumption (Government Accountability Office, 2007).
3.6 Inflation Elements
The measure of inflation that is used in inflation targeting can be defined as core or headline inflation. By meaning, ‘core inflation' excludes items of unstable price movements from the CPI, thus eliminating the temporary effect of price shocks and focuses on long-term price changes. Core inflation should be a good meter to underlying long-term inflation trend, and it provides an indication of future inflation. The core inflation should also be capable to find the components of overall price changes which are predictable to continue in the long run. This helps policy makers to use this information for short to long-term inflation prediction. ‘Headline inflation', however, looks at the rate of change in the average price of a basket of goods, consumer price index and services (Khalid, 2005).
4.0 INDEPENDENT AND DEPENDENT VARIABLE:
In this research two variables have been taken into consideration for studying the effect of international oil prices and inflation.
4.1 Independent Variable - International oil price
International oil prices fluctuate on a daily basis. These prices are regulated by OPEC and further there are governing bodies in each country which control the lead through impact. In Pakistan the governing body is OGRA.
4.2 Dependent Variable - Inflation
Inflationary rates are taken from State Bank of Pakistan and Federal Bureau of Statistics. Inflation helps in determining the rate of growth of the economy.
5.0 RESEARCH METHOD:
The research is conducted to determine the impact of International oil prices on Inflation rate.
The research is conducted on Ms-excel where the sample data was tested. Monthly average International oil prices were taken from Oil and Gas Regulatory Authority, from 2005 till 2009. And inflation rates are taken from State Bank of Pakistan. Considering the fact that, Pakistan is an oil importing developing country and the chain of oil consumption is involved in every industry thus relating till the finished goods.
The analysis data is secondary and linkage between oil and inflation is explored through it. Since the research conducted is through exploring the secondary data, the research design, is exploratory research design.
6.0 DATA ANALYSIS
To study the direct effect of oil on inflation rates I have used, a “Correlation and Regression Analysis”. It will help me identify the relationship between a single predictor variable i.e. oil (x) and the response variable inflation (y). Specifically, the interpretation of I is the expected change in a for a one-unit change in b. This is called the unique effect of b on a. In contrast, the marginal effect of b on a will be assessed during the process with the correlation coefficient relating x to y.
The above can be transformed in the following equation;
Y= a + bx
When running the regression the genuine effect of independent variables on dependent variable is studied. This is to determine if the Independent variable coefficient is different from 0, otherwise zero, means the independent variable has no effect.
In regression with a single independent variable, the coefficient tells you how much the dependent variable is expected to increase when that independent variable is zero.
The R-squared of the regression is the fraction of the variation in your dependent variable that is accounted for (or predicted by) your independent variables.
The equation is tested in Microsoft Excel and found the following output.
Table 1 Significance Level
Table 2 Regression Statistics
Adjusted R Square
X Variable 1
The above results can be summarized as;
Multiple R; represents the correlation between the two variables that has came out to be 34%. Which indicates that inflation has 34% oil prices impact.
R Square; determines how much is the impact of International oil prices on our domestic inflation which came out to be 11%.
Significance F; is 0.01 which is less than 0.05, identifying that our hypothesis is correct.
Y Intercept; determines the impact on dependent variable if independent is kept zero ‘0'. The result of our variables came out to be 6.07 meaning if oil price is zero the inflation will be 6.07.
X variable; signifies the dependence of inflation on oil price. According to our data when oil price increases inflation increases by 9%.
7.0 Conclusion & Implications:
The research findings have derived us to a conclusion, that Pakistan has a strong reliance on the imported oil. Pakistan's reliance on oil makes the country highly exposed to the oil shocks. This emphasizes the importance of energy mix. Therefore, it is anticipated that the price surge will remain higher due to demand pressures.
The demand results in the price rise of essential food items this is largely the result of widening imbalances between demand and supply forces in the market. The supply side along with monetary policy operations can overcome inflation pressures over the medium to long term periods.
Moreover, the acquisition of internal growth momentum is extremely important to absorb the severity of imported inflation in the economy. Above all, the promotion of agricultural sector is also extremely important to achieve the sustainability of internal growth momentum as well as to counter the productivity-related inflation pressures around the global economy especially in Pakistan's context.
The inelasticity in demand towards the imported oil has been a major disrupt in the whole economic process. Oil prices in terms of domestic currency highlight that the transmission channel of the world shocks via exchange rate fluctuations. The international oil prices have not been proportionally adjusted and, hence passed on to the domestic consumers. An alternative to oil can be Natural Gas, a domestic product which can have a controlled effect.
Adding to the disadvantage is the unfortunate trend of holding and hoarding stock in return of a more favorable cost advantage, leading to shortages. The exceptional circumstances arising from the stepped-up campaign against militants, huge expenditures on defense and the rehabilitation of internally displaced people are special circumstances limiting the policy options. It is quite difficult to contain such discretionary government spending.
A better investor climate can help stabilize prices. Within the framework of a national energy policy, a number of specific measures to promote energy efficiency and diversity will help in reducing vulnerability to high oil prices.