Thursday, August 18, 2005

Thinking straight about EVAT - the inflation angle

When fuel prices go up, sure it hurts our pockets. Car owners immediately feel the pinch; so do commuters, when passenger fares go up; power costs rise; many manufactured products also pass on their higher energy costs in the form of price increases; eventually even agriculture and fisheries products face higher costs (because of rising fertilizer and fuel prices.)

In that sense, rising prices are "bad". However, rising prices do play a role. For example, shouldn't you have to part with some of the commodity when there is an influx of demand from competing users? Or, shouldn't you have to do with less, when there is less of the commodity that is available in the first place?

But we can leave a discussion of the functionality of prices for a later post. For now, let's consider how much prices on the aggregate will rise as a consequence of the world oil price spike - that is, the impact on inflation. How serious is it? Is it a national emergency? (In the following I'm using official statistics available on the internet.)

Let's see: the impact on inflation depends on two things: how much prices will rise; and the consumption share of the commodities for which prices will rise. Now for the first: Dubai crude traded an average of US$ 42 per barrel in 2004, and perhaps $60 or more on average in 2005. Petroleum product prices will have to go up, proportional to the percentage of crude oil costs in their manufacture. Think of gasoline price going up by 10 pesos per liter. Then other goods and services raise prices proportional to their dependence on petroleum products, and so on and so forth.

It's difficult to estimate all this. Let's look at the consumer basket for the average Filipino in 2000 and see which ones are likely to take a hit:

Fuel and light: 6% of total spending (fuel is just 2.4%!)
Transport and communication: 7.5% (alas, no breakdown between the two - given the Filipino penchant for the cellphone, don't think transport is necessarily the bigger chunk!)

What about the rest? Food? Yes, that's 45% - but it's hard to say whether prices will rise significantly for this item, due to the oil price shock. (The El Nino effect of 1997 was probably a much much more serious source of food inflationary pressures.) How about non-food? Ah but that's mostly services and housing. Too much of a stretch to see those prices inflating seriously. So far I am unimpressed about the "crisis" terminology so loosely bandied about.

An alternative way of looking at it is by examining the import bill. Total import of crude oil in 2004 was worth - what? In US$, 2.5 billion. The total import bill was 40 billion. Right folks, that's just about 6.3% of total imports. Now the economy is produces about US$ 86 billion worth of goods and services in GDP (using the market exchange rate). That comes to just 2.9% share. And if you want to look at the impact of that on retail prices, chances are you are using a share that's too big, because GDP takes out intermediate goods (raw materials), while the retail price includes all costs (including raw materials).

Okay all of this is simply guess-timating. A more quantitative way of doing this is to run this in a good macroeconomic forecasting model. Again using the Ateneo Macroeconomic Forecasting Model, we examined the impact of a 20% increase in crude oil prices and found that inflation rises by less than a percentage point. So our crude estimates are consistent with the more systematic ones. I won't pin down the precise figures - but we are talking about numbers much less than the last big inflationary episode, the 1997 El Nino, where year-on-year inflation was 10% (was that too long ago for you?)

Now back to EVAT. Should we use oil-price induced inflation as an excuse to defer implementation? Well given the above analysis on the (un)seriousness of the inflationary threat, we'd better pay attention to the greater threat at hand - an unsustainable trend in our government borrowing. So no, deferment is not an option.

And what can I say about those ranting about threats to national survival?

Go Figure.


the emancipator said...

Can you post something about a simulation of hyper-inflation? Is it gonna cause an upward or a downward spiral of economic proportions?

Econblogger said...


I haven't run a simulation of hyper-inflation, and I never even thought about doing it!

But I have a pretty good idea of how to start one. Very rapidly increase and keep on increasing money supply. The only way to maintain equilibrium is for the price level to keep on going up at rapid clip. Now here is the crucial point - because of lags, uncertainties in BSP policy, and so forth, nobody really knows how much hyperinflation is going to be tomorrow (or even this afternoon, if prices are rising that fast). That would be devastating. Nobody would trust the currency anymore. And barter incurs far too much transaction cost. In the end, people are just going to settle on a new equilibrium - and use foreign currency (USD) as a medium of exchange.