ANALYZING THE EQUILIBRIUM AND SHORT RUN RELATION BETWEEN CRUDE OIL PRICE AND INFLATION RATE IN INDIA Dr. R. Thenmozhi* 1, Trinley Paldon 2. India.

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1 ISSN: IJMRR/ October 2014/ Volume 4/Issue 10/Article No-7/ Dr. R. Thenmozhi et. al./ International Journal of Management Research & Review ANALYZING THE EQUILIBRIUM AND SHORT RUN RELATION BETWEEN CRUDE OIL PRICE AND INFLATION RATE IN INDIA Dr. R. Thenmozhi* 1, Trinley Paldon 2 1 Prof, Dept. of Management Studies, University of Madras, Chennai, India. 2 Ph.D Research Scholar, Dept. of Management Studies, University of Madras, Chennai, ABSTRACT India. Crude oil has been of interest to many researcher or analyst as it s a vital commodity for any economy. This study adds on to the literature of analyzing long term and short term relationship between crude oil price and inflation rate of india who is the most arduous of the commodity. The study covered period ranging from 2004:Q1 TO 2013:Q4 by employing Johansen Cointegration and Unrestricted Vector AutoRegression model. The empirical test result suggest there s neither long run nor short run relationship between the two variables. Thus supported by inter alia Victor Valcarcel and Mark Wohar(2013). INTRODUCTION Crude oil is a vital commodity that is in continuous demand for economic growth for centuries now. Yet the most demanded commodity has never seen a day without any judgment. Since the world war to the 1970s oil embargo to the recent recession there has been continuous debate if oil is leading the economy or is it reflecting the economic factor at macro level. The major subtle is economic theory touts Crude oil leads to inflation atleast to those who imports the commodity but a research that is done to study the relationship between the crude oil and inflation has been of different opinion. inter alia Victor Valcarcel and Mark Wohar(2013) has analysed the relationship by employing Bayesian structural vector Autoregression and found after great moderation that is 1980s the volatility in oil prices do not seem contagious for the volatility in overall inflation. Similar to that Shiu- Sheng Chen (2009) found a country with more energy imports tends to have larger passthrough and oil price changes have lower pass-through into aggregate CPI in the 2000s than they did in the 1970s. Crude oil is as per investopedia (26, September 2014), a naturally occurring, unrefined petroleum product composed of hydrocarbon deposits. Crude oil can be refined to produce usable products such as gasoline, diesel and various forms of petrochemicals. This is often referred as black gold. Inflation is a sustained increase in the general price levels of goods and services in an economy over a period of time which is losing real value in the medium of exchange. To measure the inflation this study has taken the inflation rate that is in quarterly data referred *Corresponding Author

2 from the Reserve Bank of India database where as the crude oil price has been referred from the Index mundi with cross reference from the Indian Oil Corporations. Both the series used are in same unit of exchange that is in Rupees. AIM OF THE STUDY To know if there s long run relationship between Crude oil Price and Inflation rate from Indian perspectives. To learn short term relationships between Crude oil price and Inflation rate in India. Finding if the result supports the most recent reviews of crude oil price having passthrough effect This paper is organized as follows: Section 2 presents a brief summary of the literature of recent studies that has dealth with analyzing the relationship between crude oil price and inflation. In section 3, a brief description of the models used. Section 4, presents the data and interpretation of the empirical results. Section 5, containing some concluding remarks. REVIEW OF LITERATURE Luis J. Alvarez, Samuel Hurtado, Isabel Sanchez and Carlos Thomas (2011), assesses the impact of oil price changes on Spanish and euro area consumer price inflation. Dynamic Stochastic General Equilibrium is used. It found that the inflationary effect of oil price changes in both economies is limited however the impact on Spanish inflation was higher than the euro area. In both the economies, direct effects have increased in the last decade reflecting the higher expenditure share of households on refined oil products. Ankita Mishra and Vinod Mishra (2012), the period of this study covers from January 1996 to March This research builds on short run Vector Autoregression model. It was found that NEER and oil shocks affects inflation more than output shocks and that the increasing globalization of Indian economy, the pass-through of international prices to domestic inflation has increased as shown by VAR model. The study suggest that the demand effects of interest rate are stronger than the exchange rate and interest rate but suggested for further research on the theoretical model for monetary policy in India incorporating the stylized facts to evaluate an inflation targeting monetary policy framework in India. Kuo-Wei Chou and Yi-Heng Tseng (2011), estimated the short term and long term pass through effects of oil prices on inflation in Taiwan from 1982M1-2010M12. This study has taken rolling regression and recursive regression analyses. The empirical results showed that international oil prices experience a significant and long term pass through effect on inflation in Taiwan, though the short term pass through effect was not significant even when the international oil prices rose sharply. Juthathip and Donghyun Park (2011), who has done empirical study on inflation in developing Asia: pass-through from global food and oil shocks taking into account nine developing Asian countries: People s Republic of China (PRC), India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Thailand, and Vietnam. An econometric procedure used in the analysis are a vector Autoregression (VAR) model to be estimated and a recursive Cholesky orthogonalisation is applied to identify the primitive shock in the VAR. Copyright 2012 Published by IJMRR. All rights reserved 1015

3 Colin Bermingham _(2008) studies means of quantifying the impact of oil price increases on inflation in Irish case. The author used simple regression based forecasting technique. The data used are monthly from December 1996-May It s found the effects of recent oil price increases have been less damaging to economic growth and less inflationary. And there s improvement in the benchmark forecast for one month horizon from 20 % to 30% and from 9% to 26% for three month horizon. Giacomo Carboni and Martin Ellison (2006), studies on the theories of interactions between oil price shocks and government beliefs by using Bayesian techniques for the period They found evidence for oil price shocks playing a role in the great inflation both directly and indirectly through their impact on government beliefs. Oya Celasun, Roxana Mihet, and Lev Ratnovski*(2012), have found that U.S monetary policy can remain extraordinarily accommodative only if longer term inflation expectations stay well anchored, including in response to commodity price shocks. Oil price shocks have a statistically significant but economically small impact on longer term inflation compensation embedded in U.S Treasury bonds. De Gregorio, Jose. Landerretche, Oscar. Neilson, Christopher.(2007), have estimated the pass-through of oil price fluctuations to inflation to a larger set of countries. Traditional Philips curve and structural breaks were estimated for thirty three countries which showed clear decrease in the average estimated pass-through for industrial economies and to a lesser degree for emerging economies. The authors also used rolling VARs for subsample of countries which have sufficient data and it was found that the effect of oil shocks on inflation for a twenty four month window has decreased for most of the twelve countries in the subsample. Karl Habermeier, İnci Ötker-Robe, Luis Jacome, Alessandro Giustiniani, Kotaro Ishi, David Vávra, Turgut Kışınbay, and Francisco Vazquez1 (2009), analyses the monetary policy response to rising inflation in emerging and developing countries associated with the food and oil price shocks by taking account of inflation, monetary policy, oil price shocks, food price shock, developing countries and emerging markets in a sample of 50 developing and emerging markets.. It was found that aggregate demand and commodity prices played role in rising inflation in many emerging and developing countries. Hamad A. Altowaijri*(2011), investigates the factors that affect the rate of inflation in Saudi Arabia by using quarterly data from 1996(1) to 2010 (4). The author has employed unit root test and co-integration. The findings suggest that increase in world prices and the fall in the Dollar are found to be important determinants of the inflation rate in both the short and long run. Also the increase in domestic demand, which has resulted from the increase in oil prices, has raised the inflation rate. José De Gregorio Oscar Landerretche Christopher Neilson (2007), presents evidence of pass through from price of oil to the general price level. This study was carried out as per the availability of data.traditional Phillips curve shows result of a fall in the average estimated pass-through for industrial economies to a lesser degree, for emerging economies and estimated rolling Vector Autoregression then derived impulse response functions of inflation Copyright 2012 Published by IJMRR. All rights reserved 1016

4 to oil shocks and interpret the integrals as estimates of pass-through. We find that the effect of oil shocks on inflation has weakened for most of the 12 countries in the sample. Which the authors argued that the most important are a reduction in the oil intensity of economies around the world, a reduction in the exchange rate pass-through, a more favourable inflation environment, and the fact that the current oil price shock is largely the result of strong world demand. Benjamin Wongy (2013), studies the impact of different oil shocks on U.S inflation and inflation expectations since the 1970s, the estimation using TVP-VAR (time varying model). The findings confirm oil supply shocks have never been a major factor but rather demandside shocks determines inflation dynamics and movements inflation expectations. On these different findings the study has been carried whether there is equilibrium and short run relation between oil price and inflation in india. MODELS USED Unit root test Before proceeding further test series has to be check which model to be used which is determined if the series are stationary in nature or contains unit root. For that autoregressive model is used to test unit root that is Augmented Dickey-Fuller test. The test is named after the statisticians David Dickey and Wayne Fuller, who developed the unit root test in The most general test is test for a unit root: Where is the first difference operator with a null hypothesis of series containing unit root. Johansen Test for Cointegration When the series are cointegrated with the same order of integration then we can proceed with the Johansen Cointegration of analyzing long term relationship. Testing of a series if they are cointegrated of several I(1) time series can be done with Johansen test which permits more than one cointegration relationship. There are two types of Johansen test, either with Trace or with Eigen value but little difference of inferences. For this study Trace test has been referred with the null hypothesis stating there s no cointegration. The equation of Johansen Cointegration that is used for this study: Where X 1, t =α+β 2 X 2, k + β k X k, t I(0) X 1,t, X 2,t, X k,t is a non stationary time series variables having linear combination consisting of all variables with a vector β. Trace test which examines the number of linear combinations (i.e. k) to be equal to a given value(k0), and the alternative hypothesis for k to be greater than k0. Copyright 2012 Published by IJMRR. All rights reserved 1017

5 Where K0=0 (no cointegration ) in this case, the null hypothesis is rejected thus establishing the presence of Cointegration between the variables. Unrestricted var The unrestricted vector autoregressive (VAR) model of order k with p endogenous variables is given by: Where t=1,2,,t x t =π 1 x t-1 + +π k x t-k +ØD t + t, x t is a vector of the p variables at time t, π i are pxp matrices of parameters with i=1, k, D t a vector of deterministic components with a vector of coefficients Ø; and t a px1 vector of errors. Assumptions of VAR The VAR (K) model is linear in the parameters. The parameters are constant The error terms are identically and independently distributed and follow a Gaussian (i.e. Normal) distribution: t iid N p (0,Ω) DATA AND INTERPRETATION Table 1: Stationarity of Inflation Rate Null Hypothesis: D(CPI) has a unit root of the errors. t-statistic Prob.* Augmented Dickey-Fuller test statistic Test critical values: 1% level % level % level Augmented Dickey-Fuller Test Equation Dependent Variable: D(CPI,2) Method: Least Squares Sample (adjusted): 2004Q4 2013Q4 Included observations: 37 after adjustments Variable Coefficient Std. Error t-statistic Prob. D(CPI(-1)) Copyright 2012 Published by IJMRR. All rights reserved 1018

6 D(CPI(-1),2) C R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob(F-statistic) The computed Augmented Dickey Fuller Test statistic is smaller than the critical values at 10%, 5% and 1%( , , ) significant level, respectively. Therefore we can reject null hypothesis. It means the CPI series doesn t have a unit root problem and the CPI series is a stationary series at 1%, 5% and 10% significant level. This result is reliable because the Durbin Watson statistics is meaning the CPI series has no autocorrelation problem. Table 2: Stationarity of Crude oil price t-statistic Prob.* Augmented Dickey-Fuller test statistic Test critical values: 1% level % level % level Augmented Dickey-Fuller Test Equation Dependent Variable: D(OIL,2) Method: Least Squares Sample (adjusted): 2004Q4 2013Q4 Included observations: 37 after adjustments Variable Coefficient Std. Error t-statistic Prob. D(OIL(-1)) D(OIL(-1),2) C R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid 1.29E+09 Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob(F-statistic) Source: Computed from the secondary data The computed Augmented Dickey Fuller Test statistic is smaller than the critical values at 10%, 5% and 1%( , , ) significant level, respectively. Therefore we can reject null hypothesis. It means the Real Effective Exchange Rate series doesn t have a unit root problem and the Real Effective Exchange Rate series is a stationary Copyright 2012 Published by IJMRR. All rights reserved 1019

7 series at 1%, 5% and 10% significant level. The result is reliable as the Durbin Watson test statistics is meaning there s no autocorrelation problem. Table 3: Johansen Test for cointegration between Crude oil price and inflation rate Hypothesized Trace 0.05 No. of CE(s) Eigenvalue Statistic Critical Value Prob.** None At most Source: Computed from secondary data.* denotes rejection of the hypothesis at the 0.05 level The Johansson Cointegration indicates there is no Cointegration or long run association between oil and cpi as the maximum eigen value or trace statistic is less than 5% critical value thus accept null hypothesis. So in the long run oil and cpi doesn t move together. The guideline under such cases is that when the variables are found not cointegrated then we can carry forward with the unrestricted VAR and no need to use granger causality between these two variables. Table 3: Normalized cointegrating coefficients (standard error in parentheses) Oil Cpi C Log likelyhood Source: Computed from data on variable specified The above Cointegration relation can be expressed as: Oil: Cpi Table 4: Unrestricted VAR between Crude oil price and inflation rate Coefficient Std. Error t-statistic Prob. C(1) C(2) C(3) C(4) C(5) C(6) C(7) C(8) C(9) C(10) C(11) C(12) C(13) C(14) C(15) C(16) C(17) C(18) Copyright 2012 Published by IJMRR. All rights reserved 1020

8 Wald test of Oil and Inflation Unrestricted VAR OIL CPI R-squared Adjusted-R-squared S.E. of regression Durbin-Watson stat Mean dependent var S.D. dependent var Sum squared resid 1.21E Variables Chi-square df Probability Cpi Oil Source: Computed from secondary data From the Wald test result it shows that neither Crude oil price is influencing inflation rate nor inflation rate is influencing the Crude oil price in India. We cannot reject null hypothesis as p is more than 5 percent. CONCLUSION With the ongoing rise in demand of crude oil in a country like India who imports more than 80 percent of crude oil has been a daunting to many analyst. And there has been some contradictory opinion of the effect of crude oil price having impact on the inflation as the economic theory entails commodity leads the inflation. The series used in this study contains I(1) and thus employable for further testing by using Johansen test. From the study it can be concluded that Crude oil price is not having long run relationship and short term relationship as the test is empirically confirmed by using Johansen Cointegration test to test for equilibrium relationship and Unrestricted VAR for short term relationship. Thus rejecting Giacomo Carboni and Martin Ellison (2006),Hamad A. Altowaijri*(2011), and agreeing with kuo-wei Chou and Yi-Heng Tseng (2011), José De Gregorio Oscar Landerretche Christopher Neilson (2007) studies from the review listed in Section 2. REFERENCES Altowaijri HA. Determinants of Inflation in Saudi Arabia. World Review of Business Research 2011; Bermingham C. Quantifying the Impact of Oil Prices on Inflation. Ireland, Celasun O, Mihet R, Ratnovski L. Commodity Prices and Inflation Expectations in the United States. IMF working paper 2012; Chen SS. Oil price pass-through into inflation. energy economics 2009; De Gregorio JL. Another pass-through bites the dust? oil prices and inflation. Central bank working papers 2007; Chou Kuo-Wei YHT. Pass-Through of Oil Prices to CPI Inflation in Taiwan. International Research Journal of Finance and Economics 2011; Copyright 2012 Published by IJMRR. All rights reserved 1021

9 Park JA. Inflation in developing Asia: pass through from global food and oil price shocks. Asian-Pacific Economic Literature 2011; Valcarcel VJ. Changes in the oil price-inflation pass-through. journal of economics and business 2013; Wongy B. Inflation Dynamics and The Role of Oil Shocks: How different were the 1970s. The centre for applied macroeconomic analysis 2013; Copyright 2012 Published by IJMRR. All rights reserved 1022