Indeed, as this piece is being written, the debate on petro products pricing following the latest expert committee's report on the subject (Kirit Parikh Committee) is going back and forth. And, by the time this appears in print, it is possible that some degree of price revision does come through.

But, one can still be reasonably confident that Indian policy makers, bowing to the inevitable political pressures, would once again eschew the decisive steps the Committee has recommended to free the prices of some of the key petro products (from a largely 'unmerited' subsidies regime). In the event, it is likely the debate on petro products pricing will continue.

Not unique but really a stand out

The clarity and the decisiveness with which the Committee has recommended the case for higher product prices, of course, are quite noteworthy. But it can also be noted that such clear recommendations prima facie do not seem unique or do not stand-out in the sense of being a landmark development. There have been at least two previous committees, in the recent past, which have broadly come up with similar recommendations of freeing petro product prices and allowing them to move in line with international prices.

The really unique aspect about the Kirit Parikh report, though, is its explicit linking of petro product pricing with overall monetary policy in the country.

To quote from the Committee's report:

"With deregulated oil prices, once households and firms clearly see that international factors drive domestic petroleum product prices and when monetary policy is seen to emphasize price stability, households and firms would be relatively relaxed. When there is a temporary shock to oil prices, they would be much less likely to react to short-term fluctuations in prices through wage hikes or increases in product prices. Thus, in OECD countries, from 1979 onwards, where central banks have shifted into de facto or de jure 'inflation targeting,' the great commodity inflation from 2002 onwards did not pass through into broad-based inflation in the 2002-2008 period "

This is particularly interesting and extremely relevant for the following reasons - (1) the increasing levels of absolute energy consumption in India on the back of the economy taking off into possible a 'mature' growth phase and equally importantly (2) the fact that intensity of energy use in India, or in other words, the amount of energy consumed per unit of economic output, like in most emerging market economies, is quite high and may not fall for many years to come.

Quite simply, energy expenditure - in its various forms - is accounting for an increasing share of total national expenditure - be it the expenditure of a household or that of businesses, both in the manufacturing and services sector.

Aggregate national income and expenditure statistics show that expenditure on just petroleum, oil and lubricants (POL) has risen from around 2 per cent of total national expenditure in 1997-98 to around 8.50 per cent in 2008-09. This does not include other forms of energy (imported) and consumed in the domestic economy and as indicated above, refers only to POL imports.

Four ‘fold increase in energy consumption during 1980-2005

As the chart shows, total energy consumption has increased by a significant 4 times between 1980 and 2005 - this will probably be higher now in 2010, though updated figures are not yet available. More critically, per capita energy consumption has also increased substantially - by nearly 2.5 times in the 25 year period.

It is not difficult to understand the reasons. Not only is the overall economy taking off into a mature growth phase and consequently consuming larger amounts of energy in its production processes. At the level of households too, far more energy is being consumed than was the case 25 years ago. We have a far larger share of households using a variety of appliances such as ovens, washing machines, computers, TVs... now than earlier. The fuel efficiency of automobiles may have increased by leaps and bounds in the past 25 years. But, we have significantly higher number of autos on the roads now than in the 1970s and 1980s. In other words, while energy efficiency may have improved at least in some respects (particularly automobile technology), the rise in living standards seem to be fully consuming those efficiency gains. The sharp rise in the per capita energy consumption quite clearly shows that.

Higher cost of energy (or for that matter lower cost of energy when international prices fall) in this scenario will be reflected in higher consumption expenditure for households on energy related products and higher production costs for businesses which consume energy in its various forms.

For instance, if the share of energy / oil inputs in the production cost of a product or service is say 5 per cent, a doubling of fuel / oil prices would mean a 5 per cent increase in the marginal cost of producing the product.

(If energy / fuel can be substituted for other factors of production or if energy can be used more efficiently (higher productivity), the rise in the production costs will possibly be less than 5 per cent. But, one has to reckon with the fact that we are talking about an economy in which energy use is taking off from a low base and consequently energy intensity will be high - as a corollary, efficiency in energy use will be quite low. The chart above quite clearly shows that - energy per dollar of GDP has remained broadly unchanged in the past 25 years. The importance of this measure of energy use is also evident from the commitment on this area which was sought from India at the recent climate change talks in Copenhagen).

This rise in production costs will tend to be passed on to the selling side if the business is able to do so. The incentive or rather the compulsion for doing so will be all the more if businesses are not able to economise on other factors of production. The incentive to pass on the increases in production costs will also be strong if overall or aggregate demand in the economy does not adjust (lower) to the increase in overall energy / fuel costs but is maintained at its earlier (that is, before the energy cost increase) level.

Critical role of monetary policy

But, the real key to ensuring that higher energy costs do not spill over into overall broad based inflation in this scenario is a central bank focused on price stability or has a clear mandate to produce some level of acceptable inflation.

It is here that the central bank of a country has a hugely critical role to play in managing aggregate demand in the economy so that it is not out of line with the supply capacities of the economy. Where aggregate demand is not moderated, the economy will simply move into a higher price level (range), not only generating higher (current) inflation but also higher inflationary expectations.

When energy / fuel prices rise and, therefore, all production / consumption costs increase, a central bank with a price level target will not (or should not) accommodate any higher aggregate demand in the economy. Such higher aggregate demand is implicit if companies and households do not feel any compulsion to adjust or lower their overall expenditures despite the higher energy / fuel prices. Consumers are confident, in such a scenario, that they will obtain the required increases in their nominal incomes which will enable them to spend as usual.

What is required of the central bank in such a situation, therefore, is ensuring that increases in relative prices (that is, of one particular commodity such as oil / energy) do not result in the overall price level (s) itself increasing. The average level of prices should not be affected by changes in the price / cost of some things relative to others.

This requires that the central bank has a clear price level mandate. Highlighting this point may well be the most important achievement of the Parikh Committee report.