Indexing inflation

Indian Express, 11 February 2011

As India grapples with the problem of high inflation, the issue of inflation measurement assumes importance. People sometimes feel that prices are rising faster than the headline inflation numbers reported by the government. This is not unreasonable if the government's statistical system does not correctly measure prices of the goods that people consume, or take into account the structure of household expenditure. In India this problem has been made worse by the media and policy focus on wholesale prices (WPI), instead of consumer prices (CPI). The existing CPI measures are a better measure of what is going on. The CPI is about to be improved significantly. In addressing our inflation crisis, policy makers and the public at large need to devote their focus to inflation as seen in the CPI.

In recent years, consumer price inflation in India has slowly crept up. There are 4 measures of CPI, which have broadly moved together. The CPI for Industrial workers (CPI-IW) is the one with the most recent weights. The year-on-year change of the Consumer Price Index measured by this index has exceeded 5 per cent in every month of the last five years. This contrasts with most other emerging economics who have, in general, witnessed low inflation, especially after the global financial crisis of 2008.

At present, monetary policy in India is not explicitly charged with delivering low and stable inflation. Even then, monetary policy needs to care about inflation, given that in the long run, inflation is always a monetary phenomenon. In this context, a major problem identified by the Reserve Bank of India (RBI) is the measurement of inflation in India.

In a recent paper on inflation measurement in India, my colleagues and I examined detailed price data, expenditure patterns of households and the composition of different price indices available in India.

Internationally, `producer price indexes' are widely used. These reflect 'factory-gate prices', valued from the producer perspective. In contrast, the Indian phrase `wholesale price' may record prices paid at various stages of the distribution chain: starting from prices of raw materials for intermediate and final consumption, or prices of intermediate goods, to prices of finished goods up to the retail stage. Furthermore, the price data used in the WPI may sometimes contain discounts and rebates, taxes and subsidies on products, as well as trade and transport margins. In addition, the weights in the WPI do not reflect the consumption of the average household.

Increasing trade integration coupled with the domestic liberalisation of administered prices has turned a growing fraction of the WPI basket into tradable goods, whose prices are determined in international markets. The evidence shows that the WPI tends to move with producer prices of other countries, as a consequence of the substantial share of tradeables in the WPI.

The domestic WPI is thus strongly influenced by the fluctuations of global prices of tradeables and the fluctuations of the rupee. Domestic monetary policy has no impact on global tradeable prices. In addition, now that India has moved towards a flexible exchange rate policy, domestic monetary policy does not involve an administrative control of the exchange rate.

There is a sharp contrast between wholesale price inflation, where it is seen that a range of countries have similar tradeables inflation, and consumer prices which show a marked divergence of consumer price inflation across the same countries.

For these reasons, the WPI, while continuing to be a valuable source of data, should be demphasised in the discussion of inflation outcomes. The central bank should focus on the unique features of each domestic economy, rather than on the common factor of global tradeables inflation.

To gauge the extent of the information delays in the consumer price index basket, we compare it with the CMIE Consumer Pyramids, a dataset drawn from a panel dataset where over 120,000 households are surveyed each quarter, for which we have a detailed level breakdown. The weight of food in the Consumer Pyramids dataset is similar to that seen in the CPI-IW. Within food also, we find that the distribution of expenditure is not too dissimilar across the two sets of weights. This increases our confidence in the CPI-IW.

The national consumer price index, which is going to be soon released, will measure both urban and rural consumer prices. It will be based on the latest weights in the most recent 2004 round of the National Sample Survery of household expenditure. We may expect that these changes will further increase confidence in the CPI.

Two other issues in data quality of the CPI are food prices and the prices of services. When food prices in the CPI are compared to those from other sources like the Ministry of Agriculture or data collected by NCDEX, it is found that the data in the CPI broadly corresponds with the information from other sources. This gives further confidence in the CPI.

Second, while services account for half of Indian GDP, and a large share of household consumption expenditure, there is no price index for output prices in this sector, neither at the consumer nor at the producer level. The only price series available for some services prices are those that have always been routinely collected in the CPI surveys (in particular for the CPI-IW).

Confidence in the information content of the CPI-IW suggests that the acceleration in year-on-year inflation beyond 5 per cent from early 2006 onwards should be seen as a serious problem. The problem of high and volatile inflation should not be downplayed on the grounds that it is based on low quality information.

The Central Statistical Office's plans of releasing a new CPI series for India in February 2011 lends fresh salience to this question. This new CPI is likely to become the best candidate for a headline inflation indicator, through significant improvement upon existing price indices in terms of representation, quality of price collection and weighting. The release of this new CPI is a natural opportunity for RBI to de-emphasise other inflation measures and focus on the new CPI.

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