Student: Professor, in the class you mentioned that macro-economics is a dismal science. You didn’t mean it. Did you?
Professor: I meant. I will explain. Currently there is a civil war raging in Iraq. The Sunni insurgents are fighting a non-winnable war with the Shias. In the meanwhile, the output of oil in Iraq is dropping rapidly to fall below 3 mln barrels a day. The prices of WTI and the Brent Crude today are around 108 $ and 115 $ a barrel respectively. While the oil exporters are gloating over the price increase, the oil importing countries are hurting badly. As far as we are concerned, we spent $ 165 bln dollars on oil imports last financial year. Given the price increases, we will see both our trade and budget deficits piling up for FY 14-15.
Student: Is oil that important component in our inflation rate?
Professor: You better believe it. The government has a choice. The government can either pass on the increased cost directly to the consumer, in which case the rate of inflation will increase further. Alternatively, the government could continue to subsidize by increasing the budget deficit which eventually have to be paid with interest by your generation. Dr. Rajan has targeted to keep the inflation rate at 8% for FY 14-15 and 6% for FY 15-16. His target will be missed certainly. He may be forced to increase the Repo rate at a time when the economy is faltering.
Student: Professor, can the inflation rate go up?
Professor: It is difficult to judge. We have a big supply chain between the producer and the final consumer. There are too many intermediaries including the transportation and warehousing. The cost of goods produced will increase at each level of intermediaries and the resultant final product cost at the retail level will have spiralled up significantly. You just need to look at the vegetable prices today. There are almost double as that of last year.
Student: Professor, they say that el nino effect will also be negative news as far as the rate of inflation is concerned. Is it true?
Professor: In the first three weeks of June, we have been told by the meteorological department that the quantum of rainfall for this period is 46 percent deficient. This will push up the cereal prices substantially. Besides, all cereal prices are correlated. If the price of rice go up, it will push the prices of wheat, Ragi, Bajra, etc.
Student: Sir I understand now why you call the macro economics a dismal science. We always believed in the traditional demand supply theory along with the price equilibrium. You are telling us now that there are things beyond that.
Professor: You must understand that macro economics is about the price giver and the price taker. When a scarcity is created due to a host of reasons, the price giver (For example, producer) is jumping with joy. He can push up the cost and pass it to the price taker (For example, consumer). This is a continuous process. There is never an equilibrium and everything is transient. We need to be prepared for these volatility. For example, if the civil war becomes a full scale war involving the Kurds, Sunnis and Shias across the Syrian, Iraqi, Iranian and Turkish countries, there is no telling how high the oil prices could go up. All predictions therefore should be accepted with a pinch of salt.
Student: Thanks for the informative session. I understand now as to why it is such a challenge to predict the future prices of any commodity.