Aids policymakers, not the consumers

Mon, May 12 02:54 AM

The current bout of inflation has invited a number of reactions-a plethora of explanations from economic observers, a string of responses from policymakers and some thoughts on the data generating process. The explanations can be classified into two sets: (a) a global phenomenon having some ripples in India as the economy is now more integrated with the rest of the world than before; and (b) the price paid for continuously postponing tackling the issues of the agriculture sector. While the policy responses are yet to bear its fruits, thoughts about reorganising the data generation have gathered momentum.

The consumer price index (CPI) is used to measure inflation in countries such as the US, UK, Japan and China, while in India we use the wholesale price index (WPI). WPI measures price changes from the production side and not from the consumption side, and does not capture price changes in the service sector. CPI calculation is flexible enough to accommodate changing consumption patterns, migration and social trends. In a growing economy like India, people's consumption pattern changes fast, necessitating a review of the measure of inflation and perhaps even shift from WPI to CPI as in the past these two have shown divergent trends.

Recent evidence in consumption pattern like the case of better protein intake in the post-2000 period shows a shift in consumption in certain income groups, which WPI is unable to capture based on measures of price changes due to the rigid weighting pattern. Interestingly, such concerns do not figure in RBI's report of the internal technical group on seasonal movements in inflation, which instead proposes a month-over-month measure of WPI.

The argument for a month-over-month measure stems from the fact that "all the price series in India (viz, WPI, CPI) have peak/trough months around the same time of the year, mainly due to the seasonality in food prices, which are the major source of seasonality in all price indices". As food prices are the most important determinant of inflation in India, this seasonality is likely to be reflected in inflationary measures also.

However the extent of seasonality varies from commodity to commodity. Fruits and vegetables exhibit the most seasonality in prices, followed by foodgrains. In the case of the former, weekly variations in prices are likely to be more pronounced and any monthly measure would mask these fluctuations. While in the case of the latter, given current global anxieties, international price transmissions are likely to be more in the future, increasing the volatility of prices. The likely implications of commodities futures trade has also to be borne in mind.

Apart from the seasonality of food articles, one has also to reckon with the volatility of oil prices. Given our import dependence and global price changes, oil prices fuelling inflation in India needs no elaboration. International oil price variations leave two components on Indian prices-a small but permanent effect and a bigger transitory effect. The transitory effect dies down over time and cannot be captured over longer time durations such as a month. Hence, a monthly measure of inflation would capture only a miniature effect of oil price changes, leaving the larger picture aside. As the economy opens up more, these effects are likely to increase primarily due to variations in exchange rates.

The fact that the RBI report accords primacy to food price seasonality for a change in inflation measurement in a way downplays the effect of monetary policy on prices. Inflation is driven by food prices, but the single-most policy instrument of RBI-monetary policy-also claims to arrest inflation. The short-run implication of monetary policy changes go unnoticed if we move to a monthly measure.

Output responses to credit availability due to changes in interest rates are fast, with very short adjustment lags. These effects on prices, due to short-run supply shocks, help us evaluate the effectiveness of policy instruments. Such possibilities become difficult with monthly measures. Equally important are the demand responses to tight/easy money policies, which cause spikes in the inflation. Seasonally adjusted monthly measure of prices ignores this demand-pull inflation focusing only on the supply-side aspects.

On the whole, a month-over-month measure of inflation would appeal to policymakers as it provides a smoothened measure of inflation and time to react to price shocks. But for consumers, the short-run damage would go unnoticed. In any case, it raises some important questions on measuring inflation and the need for a reliable barometer of price rise in the economy

-The writer teaches economics at the Indian Institute of Technology, Chennai

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