Vidya Mahambare
There is no doubt that, conceptually, retail inflation?price rise driven by potential consumer demand and available supply?is a better indicator of inflation for guiding monetary policy decisions than WPI inflation. Even the former RBI governor D Subbarao admitted as much. The release of CPI data, with a shorter time lag and availability of a single all-India measure of retail inflation, could prompt RBI to move towards CPI or its variation as a primary measure of inflation.
The new RBI governor, Raghuram Rajan, has set up a committee to revise and strengthen the monetary policy framework. This committee is looking to recommend an appropriate nominal anchor (implying a measure of inflation) for monetary policy conduct, among other objectives, in its report scheduled for December 2013. Thus, the January 2014 monetary policy review could reflect the change in RBI?s stance on the appropriate inflation measure.
So far, RBI chose the wholesale price index or WPI over CPI, largely for two reasons. First, until 2011, there was no single CPI, representative of the whole country. There were three or four CPI measures, relevant for different segments of population. Now, we have one representative measure of retail inflation with further disaggregation to see how prices in rural and urban India are changing. Second, WPI was earlier available with a shorter lag?only a 2-week delay?compared with CPI inflation which came with a 2-month lag. Now, CPI monthly inflation data is released couple of days prior to WPI inflation data for the same month.
The conceptual case for moving to CPI rests on two points. First, WPI excludes prices of services such as education, healthcare, and rents. However, services now account for nearly 60 per cent of GDP and a vast majority of these services are not traded with other countries. As a result, inflation in these services is largely determined by the domestic demand-supply situation. Conversely, the new CPI measure assigns nearly 36%weightage on services and includes price changes in housing, education, healthcare, transport and communication, personal care and entertainment. CPI, therefore, is a better reflector of demand side pressures in the economy, than wholesale prices.
Second, WPI assigns nearly 15% and 10.7% weightage for the fuel group and metal and metal products group, respectively. Any sharp movements in international prices of fuels and metals, therefore, lead to sharp changes in WPI. This was visible in calendar year 2009 when WPI inflation fell below 2%, in 8 out of 12 months. A sharp decline in WPI resulted in a swift and sharp lowering of the repo rate to 4.75% by April 2009 from 9% in July 2008. During the same year, CPI (industrial workers) inflation averaged nearly 11%.
Such differences in coverage and weightage in WPI and CPI at times lead to diverging trends and make it difficult to gauge the underlying inflationary pressures. For example, WPI inflation fell to 3.9% in 2009-10 from over 8% in the previous year. In contrast, CPI (industrial workers) inflation rose to 12.4% in 2009-10 from 9.1 % a year earlier. Similarly, in recent months, while WPI inflation has risen to 6.1% in August from 5.2% in June, CPI inflation has declined to 9.5% in August from 9.9% in June.
Retail inflation is a superior indicator of the underlying demand situation in the economy, which determines the extent to which retailers can pass on a sustained rise in wholesale prices. While, in a strong demand environment, retailers can pass on the entire increase in wholesale prices or even more to their end-consumers, if demand remains weak, retailers could witness pressure on margins.
While there is little doubt that RBI will soon begin to consider CPI as a primary measure of inflation, it might have to make some adjustments to the overall CPI. The monetary policy has limited efficacy to deal with the direct impact of food and fuel inflation. Currently, food and related products account for nearly half (49.7%) of the new CPI. To arrive at a more appropriate indicator for monetary policy decisions, it would be better to exclude prices of the fuel group and those food articles which are influenced by temporary, but sharp fluctuations in supply and can result in highly volatile prices.
The author is principal economist, CRISIL
Surjit S Bhalla
For 11 continuous years, from 1996 to 2007, all the three inflation indicators?WPI, CPI and GDP deflator?were showing the same trend and the same magnitude in inflation. But since 2008, the situation has changed with CPI showing much higher inflation?about 3 to 5 percentage points?than either the WPI or the GDP deflator.
The RBI policy of keeping interest rates high has been defended on the basis of high CPI inflation. It is also argued that the apex bank should have tightened more or begun fresh tightening measures to bring down double digit inflation. But is inflation in double digits or even close? The latest yoy GDP deflator inflation is 5.8%, the lowest since 2007, and that is likely the representative inflation rate in the economy. By definition and construction, the GDP deflator is a more comprehensive measure of inflation. But because of its more timely nature, most analysts take the CPI as a surrogate.
There was a close relationship between the CPI and GDP deflator. On average, the difference in the inflation shown by the two variables was less than 0.25%. This held true for the long time-period, 1980 to 2007. For this 28-year period, average CPI inflation was 7.6% per annum, and average GDP deflator inflation 7.2%. Around 2007, this historic equivalence broke down. For the last five years, CPI inflation has been 9.6% per annum and GDP deflator 6.8%, an annual difference of 2.8%. According to the GDP data for 2012-13, this difference is 4.2 percentage points.
The reason for this large anomaly is food inflation. Over the last six years, this high food inflation was literally engineered by the UPA government via massive increases in procurement prices for food. In the space of three short years, 2006-08, the relative price of food increased by 33%. This relative price increase caused food inflation to cause the large divergence between the GDP deflator and the CPI. The latter has a near 50% weight of food, while the former has a weight of agriculture of less than 18%.
The divergence is large, very large. The difference is so large that it changes the very nature and interpretation of monetary policy. It suggests that the RBI, fully supported by the PM’s Economic Advisory Council headed by C Rangarajan, has been fighting inflation that it could not affect. Food inflation in India is political inflation, and inflation caused by administered, not market, prices. Monetary policy cannot affect the magnitude of administered prices. Food inflation is not the inflation that the RBI or the ministry of finance or the RBI should be looking at.
There are two very strong implications of this misguided misreading of inflation. First, in contrast to protestations of the RBI, there is a divergence of 4 percentage points in the real rate of interest. If the lending rate is 15%, and inflation 6%, then most borrowers are paying 9% real; with the CPI, the real rate is “only” 5%. Is it any wonder then that the economy has stalled, and stalled at near historic low growth-rates of 4.5% for the better part of the last two years?
Most investors do not have the time, inclination or expertise to even begin to question the words of a central banker. They take it as given that the RBI must know what it is talking about and if the RBI governor says that inflation has been 10% plus for the last few years, then that must be the case.
So, what should be done? There are countries like Brazil and Indonesia who are hiking rates, not because of tapering, but because their correctly measured inflation rates have accelerated beyond their “targets”. India has the opposite problem. And regardless of whether one is an inflation target policy believer or not, one should be recommending to India that it cut short-term rates, not raise them.
India’s growth recovery can only begin once policymakers (and their advisors) recognise they have made some errors of data interpretation and monetary policy. Core inflation is not high in India, food inflation is. Monetary policy should not be targeted to bring down the price of oil; nor should monetary policy be targeting administered prices induced food inflation.
The author is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company
