Petroleum Secretary S Sundareshan, while addressing a press Conference on Friday, announced the government’s decision to deregulate prices of petrol. Petrol prices shall now be subject to periodic revisions based on fluctuations in market prices. An immediate hike of Rs. 3.50 per litre has already been affected. Prices of diesel shall be deregulated in stages while those of kerosene and LPG shall continue to be regulated by the government. For the moment, diesel has been hiked by Rs. 2 per litre, kerosene by Rs. 3 per litre and LPG by Rs. 35 per cylinder. Crude to retail: Pricing and under-recoveries India imports about 80% of its crude oil requirement. Therefore, the cost of petroleum products in India is linked to international prices. The Indian barrel of crude cost $78 in March 2010. Once crude is refined, it is ready for retail. This retail product, is then taxed by the government (both Centre and State) before it is sold to consumers. Taxes are levied primarily for two reasons: to discourage consumption and as a source of revenue. Taxes in India are in line with several developed nations, with the notable exception of the US (See Note 1) Before the current hike, taxes and duties in Delhi accounted for around 48% of the retail price of petrol and 24% of the retail price of diesel. (Click Here for details) Ideally, the retail prices of petroleum products should then be determined as: Retail prices = Cost of production + taxes + profit margins However, in practice, the government indicates the price at which PSU oil companies sell petroleum products. Since these oil companies cannot control the cost of crude (the primary driver of the cost of production) or the taxes, the net result is an effect on their profit margins. In cases where the cost of production and taxes exceeds the prescribed retail price, the profit margins become negative. These negative profit margins are called ‘under-recoveries’. When international crude prices rose above $130 in 2008, under-recoveries reached an all-time high of Rs. 103,292 crore. Even at much lower prices in 2009-10 (averaging at $70 per barrel), under-recoveries totalled Rs. 46,051 crore. (See Note 2) The latest move is an effort to reduce these under-recoveries. The government cited the recommendations of the Kirit Parkih Committee while announcing its decision (Summary - Kirit Parikh Committee report). Any alternatives to price hike? As is evident from above, under-recoveries can also be reduced by decreasing taxes. In fact, one might argue that by both taxing the product and offering a subsidy, the government is complicating the situation. Usually whenever subsidization coexists with taxation, it serves the purpose of redistribution. For example, taxes might be collected universally but subsidy be granted to the weaker sections only. However, this is not the case in the current situation. What needs to be noted here is that these taxes are a very significant source of revenue. In fact, the total taxes paid by the oil sector to the central and state governments were around 3% of GDP in 2008-09 (See Note 3). Reducing taxes now might make it difficult for successive governments to raise taxation rates on petroleum products again. Moreover, though taxes are levied both by the Centre and the States, the subsidy is borne only by the Centre. Hence, the current arrangement is beneficial to the States. Possible future scenarios The opposition has voiced concerns that the hike in prices is likely to lead to even higher inflation and will further burden the consumer. The Chief Economic Advisor to the Finance Ministry, Dr. Kaushik Basu, however, told the media that these changes would have a beneficial effect on the economy. According to him,
"The (decontrol of petrol prices), coupled with price increase for LPG (cooking gas) and kerosene, will have an immediate positive impact on inflation. I expect an increase of 0.9 percentage points in the monthly Wholesale Price Index (WPI) inflation".
However, he added, that since the hike in fuel prices would push down fiscal and revenue deficit,
"they will exert a downward pressure on prices… More importantly, from now on, if there is a global shortage and the international price of crude rises, this signal will be transmitted to the Indian consumer. It will rationalise the way we spend money, the kinds and amount of energy we use, and the cars we manufacture. It is an important step in making India a more efficient, global player”.
It remains to be seen how the actual situation pans out. Notes 1) Share of tax in retail price (%)
Source: Petroleum Planning and Analysis Cell, PRS (Data as of Feb, 2010) 2) Under-recoveries by oil companies (Rs Crore)
|Year||Petrol||Diesel||PDS Kerosene||Domestic LPG||Total|
Source: Petroleum Planning and Analysis Cell, PRS 3) Contribution to Central and State taxes by Oil Sector (2008-09)
Source: Petroleum Planning and Analysis Cell
The Monetary Policy Committee (MPC) has decided to conduct an off-cycle meeting today to discuss the failure to meet the inflation target under Section 45ZN of the Reserve Bank of India Act, 1934. As per the Reserve Bank of India Act (RBI), 1934, MPC is required to meet at least four times each year, to discuss the macroeconomic issues in the country, and take policy decisions to address those. This is the second time MPC has conducted an off-cycle meeting in 2022-23. The meeting is scheduled in light of inflation being consistently high for nine consecutive months.
In this blog, we discuss what the inflation targeting framework is, examine retail and wholesale prices, and the divergence between them.
What is the inflation targeting framework, and what happens if inflation is persistently high?
In 2016, Parliament amended the RBI Act, 1934 to change the monetary policy, and introduce an inflation targeting framework. This framework prioritises price stability to achieve sustainable GDP growth. Price stability allows investors to confidently invest their money for productive activities, without worrying about it losing value. Price stability also maintains the purchasing power of consumers, i.e., the ability to purchase a good (or service) with a given amount of money.
As per the new framework, the central government, in consultation with RBI sets: (i) an inflation target, and (ii) an upper and lower tolerance level for retail inflation. The target has been set at 4%, with an upper tolerance limit of 6% and a lower tolerance limit of 2%. The upper and lower limits indicate that although it is desirable for inflation to be close to 4%, deviation between these limits is acceptable. The target and bands are revised every five years. In March 2021, the existing targets were carried forward.
Retail inflation has been above 6% for the past nine months, and it has been above 4% from October 2019 onwards (See Figure 1).
Figure 1: Consumer price index (year-on-year; in percentage)
Sources: Database on Indian Economy, Reserve Bank of India; PRS.
If inflation is above or below the prescribed limits for three quarters, RBI must submit a report to the central government explaining why prices have been rising (or falling) persistently, what will be done to correct that, and an estimate as to when the target will be achieved.
The MPC uses tools such as interest rates to control the level of inflation in the economy. One such rate is the policy repo rate, which is the rate at which RBI lends money to banks. An increase in the policy repo rate makes borrowing money more costly, and hence is expected to control inflation by reducing the money supply. MPC increased this rate from 4% in April 2022 to 4.4% in May 2022, to 4.9% in June 2022, to 5.4% in August 2022, and to 5.9% in September 2022.
Breaking down the Consumer Price Index and the Wholesale Price Index
Consumer Price Index (CPI) measures the general prices of goods and services such as food, clothing, and fuel over time. Retail inflation is calculated as the change in the CPI over a period of time. Goods and services such as petrol, food products, health, and education are considered for its calculation, which are assigned different weights (See Table 1). Between February 2022 and August 2022, the average annual inflation was 6.9%. The rise in prices of subcomponents of the CPI during this period is indicated in Table 2.
Table 1: Assigned weights for the calculation of CPI
Sources: MOSPI; PRS.
Table 2: Average inflation of some CPI components
Sources: Database on Indian Economy, RBI; PRS.
CPI is not the only index that measures inflation in an economy. The Wholesale Price Index (WPI) measures the wholesale prices of goods. A change in wholesale prices reflects wholesale inflation. Table 3 indicates the weights assigned to goods for calculating the WPI. Manufactured goods include metals, chemicals, food products, and textiles.
Primary articles (23%) include food articles, and crude petroleum and natural gas. Fuel and power (12%) include mineral oils, electricity, and coal. WPI has remained above 10% from April 2021 onwards. It reached an all-time high of 17% in May 2022. This was driven by the inflation in metals, kerosene and petroleum coke, fruits and vegetables, and palm oil.
Table 3:Assigned weights for the
Sources: Ministry of Commerce and Industry; PRS.
Why has WPI inflation been consistently above CPI inflation?
Movements in the WPI have an impact on the CPI. For almost a year and half, CPI inflation has remained below WPI inflation. However, as per the design of the indices, it is expected that CPI would remain above WPI, and that any increase in WPI would reflect in the CPI after a time lag. This is because retail prices include taxes (as a percentage of price), while wholesale prices do not. Additionally, some of the goods in WPI act as inputs in the goods considered in CPI. An increase in input prices would lead to higher retail prices after a time lag.
We discuss possible reasons for why CPI has remained below WPI for a year and a half.
Figure 2: Consumer Price Index and Wholesale Price Index
Sources: Database on Indian Economy, Reserve Bank of India; PRS.
Composition of indices
As indicated in Table 2 and 3, the composition of the two indices varies. For instance, prices of manufacture of basic metals, chemicals, and machinery grew at an average rate of 13% between February 2021 and September 2022. They contribute 7% to the WPI. These are input goods for producing final goods and services such as automobiles, which are included in the CPI. The rise in prices of transport vehicles, communication devices, fuel for transport, and housing (CPI components) rose by 6% during this period.
The Ministry of Finance has observed that wholesale prices did not feed into retail prices (from March 2021 onwards) as wholesalers absorbed the rising input costs and did not pass them on to retailers. In August 2022, it noted that as retail prices are rising now, the pass-through may occur.