In the number soup

Indian Express, 2 June 2008

The WPI based inflation rate has crossed 8 percent. Inflation data in recent weeks has become a source of short-term, short-sighted measures by the government to control prices. Measures such as banning exports or imposing high export duties and banning futures markets are likely to hurt the investment climate and do nothing to control prices. As a result of the sharp increase in prices in March, inflation numbers in the coming 6 months are likely to remain high.

High growth of liquidity last year and the rupee depreciation of last month might also push up prices further. However, panic reaction such as higher interest rates or direct price controls must be avoided. At this moment it is important that the public understands the projected path of inflation for the next few months. Better measurement and communication needs to be an essential element of government policy.

The rate of increase of prices, or inflation, can be measured in many different ways such as year-on-year, month-on-month or week-on-week. One method of measuring inflation is to measure the increase in prices over the same period last year. Since there is seasonal variation in prices, this simple measure is often used. It makes sure that mango prices in May 2008 are compared to mango prices in May 2007. This 'year-on-year' growth is traditionally the inflation figure reported in India. The 7.8 percent based inflation in the Wholesale Price Index (WPI) is the increase in WPI over the increase in WPI last year.

This measure is not useful in telling us how prices are moving today. If the price of steel is stable all year, goes up in one week by 10 percent, and then does not increase the rest of the year, the 'year-on-year' inflation in steel will be 10 percent that week and will continue to be high for the next 51 weeks. This could give the false impression that steel prices are continuing to rise sharply.

Week-on-week or month-on-month inflation measures are contaminated by seasonality and data not adjusted for these regular patterns can be meaningless. The standard procedure, therefore, consists of first seasonally adjusting the data and then computing week-on-week or month-on-month inflation. In the case of a one time change in steel prices, this would should show an spurt in the inflation rate in one week and then there would be zero inflation. This gives us a good sense of how prices are moving today. This is important because this tells us how we need to react to inflation. If inflation is moving up very fast, we need to brake hard. Today, for example, this measure shows that in the last 5 weeks inflation has declined. Inflation started coming down since the first week of April. The annual rate, based on the week-on-week deseasonalised inflation numbers has fallen to 4.7 percent. This is largely due to the pass-through of lowered non-oil global commodity inflation.

However, even though weekly inflation has come down, the year-on-year inflation measure will continue to show high numbers. According to a recent analysis by the IMF, even if weekly inflation in India falls to zero, inflation will rise to 8 percent by November and then will slip down to 6 percent. In a more realistic scenario, if weekly inflation remains at the present level of 4.7 percent, the year-on-year figure will rise to 9 percent by June and fall to 6 percent only by February. For the inflation rate to come down to 6 percent over the next one to two months, there has to be a sharp fall in the inflation rate. While this is possible, it is unlikely. As a result, the pressure to do something to control inflation will remain strong for at least the next 6 months. This could lead to further pressure for distortionary policy measures that could have an adverse impact on the investment climate, consumption demand and industrial growth.

If the public only watches the year-on-year inflation number every week, as it does today, and this number keeps getting higher as it is likely to for a few months, there will be expectations of higher inflation. Inflationary expectations are known to generate momentum in inflation. If people expect high inflation, then firms raise prices and this generates more inflation. Technically sound analysis and honest communication by the government is of critical importance in checking inflationary expectations. This requires work on measuring inflation, diagnosing its sources, showing forecasts, and estimating the impact of various policy initiatives in the past and in the future.

Such communication is done in many countries through an "inflation report" by the Central bank, which is entrusted with inflation control. The Bank of England, for example, produces a quarterly inflation report. In India too, an inflation report should be produced that has a detailed and clear analysis of inflation. It should discuss different measures of inflation, what each measure says, the impact of global oil and food prices and the impact of the exchange rate on the inflation rate. It should examine trends in global food and oil prices, their impact on domestic prices in India as well as the likely impact of various policy measures on prices. It should discuss the effect of demand, agricultural and industrial growth, of monsoons and investment activity on wholesale and consumer prices in India. It should make projections about the effect of money supply growth, liquidity credit and interest rates on prices.

An important contribution of such a report today would have been to analyse how the high growth of liquidity and the depreciation of the exchange rate is likely to affect prices. Right in December, weekly seasonally adjusted data for inflation showed that inflation was moving up. However, the RBI bought USD 13.6 in January to prevent appreciation, another USD 3.9 billion in February, actually engineering a depreciation, and a further USD 2.8 billion in March. This policy also injected liquidity into the system. It was inconsistent with the objective of controlling inflation. A well designed inflation report would help create an early warning system for inflation to control inflation more effectively.

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