Getting the right inflation measure

http://www.thehindubusinessline.com/2007/07/06/stories/2007070650020800.htm

Friday, Jul 06, 2007
When inflation is discussed as the measure of prices affecting the common man, why should the Wholesale Price Index be used, when the more relevant Consumer Price Index reflects better the prices at the retail level, and that too with the focus on various classes of consumers, ask and V. SHUNMUGAM D. G. PRASAD.

The so called aam aadmi, or the common man, comes into focus when the media and policy-makers wake up to rising prices, and his hardships, so far unnoticed, get instantly highlighted. Though increasing inflation certainly impacts the aam admi, do the numbers one reads or hears of in the media really affect his spending pattern?

In India, the Wholesale Price Index (WPI) is the official measure of inflation and its effect on the consumption pattern of the common man; so, the question is whether the WPI is a precise indicator of inflation, especially when we talk about the ultimate consumer in the economy. Basically, the WPI, as its name indicates, is designed to measure the changes in prices at the wholesale transaction of all commodities.

The other key measure of inflation is the Consumer Price Index (CPI), which is oriented towards the spending of a family of largely homogenous target population in any economy.
Apart from tracking items that have more relevance to a particular class of masses (ultimate consumers) compared to the WPI, the CPI even accounts for the retail margins and taxation and levies at the retail level that would directly impact the ordinary citizen’s consumption pattern.
The question is, when inflation is discussed as a measure of prices affecting the aam aadmi, why is the WPI used when the more relevant CPI reflects better the prices at the retail level, and that too with the focus squarely on var ious classes of consumers. In fact, both have their benefits and limitations. A look also at the other issues so as to identify the more appropriate index as a yardstick for inflation.

The CPI remains the official barometer of inflation in many countries, such as the US, the UK, Japan, France, Canada, Singapore, and China. Of course, the constituents of the commodity basket for CPI measurement vary from one country to other, as do their consumption patterns.
In most countries mentioned above, the economic authorities review the commodity basket of the CPI at least every four-five years, or whenever they think it deserves a review. In the case of non-food items, there is in various countries an increased weightage for telecommunications and extended coverage of modern information and communication technology products.

Non-food components
Most of the countries referred to above have even included health, recreation, and cultural functions, considering their share in the total expenditure. For instance, even the cost of ‘Tummy Tucks’ and ‘Nose Jobs’ form a part of the CPI in Spain, which uses this index to measure inflation.

But, unfortunately, in India this shift has been overlooked and we still look at those items that are slowly becoming less important and voicing concern about increase in prices of some commodities that are losing their share in total consumption.

In the present-day context, where people’s lifestyles and consumption patterns are changing rapidly, there is a need to review the CPI regularly to make it a more appropriate measure of inflation.

Policy-makers often track the WPI as it indicates the price movements well before the commodities hit the retail market so they can take the necessary steps well in advance to rationalise prices at the retail level. Theoretically, this could be right but analysis shows it need not always be so. The effect of the crude oil price basket on the CPI and the WPI was analysed, it being a key influencing factor on inflation. One interesting finding was that the correlation between the Indian Crude Basket (ICB) and the two-month lagged WPI was the highest, at 90.81 per cent.

As for the ICB vis-À-vis the CPI, again the two-month lagged CPI had the highest correlation. This indicates that both the WPI and the CPI more or less reflect the effect of price movements in the crude markets around the same time. India follows an administered price mechanism (APM) in pricing crude oil and derivatives, thus preventing both the indices from getting influenced directly by global crude oil prices. Yet, theoretically, the WPI should capture the effect of a global rise in crude oil prices well in advance of the CPI. Further, the volatility of the WPI is 0.55 per cent while that of the CPI is 0.82 per cent. This indicates that the CPI, which is closer to the common man, should be watched more closely than the WPI to rightly assess the impact of inflation on the common man.

An interesting dimension of this analysis is that, though there is an APM operating in crude oil/derivatives, the effect of the prices at which the Indian Crude Basket is purchased is captured only with a lag. Hence, the lower crude prices in the global market during the first two months of this year are expected to reflect on the inflation trends in the coming period.

So, the policy-makers need not worry excessively about inflation as it is supposed to come down in the near future combined with the arrival of foodstuff, post harvest, in the market and with the timely onset and satisfactory progress of monsoon. This is supported by the fact that the ICB had fallen last October and November, which was reflected in the WPI for December (valued at 207.9) and January (208.5). Is this, then, the right time to shift to the CPI as the official indicator of inflation? The answer might differ betweeneconomists.

Perhaps, then, it is time to take a look at the commodity indices compiled by the futures exchanges and to try and strengthen trading in futures derivatives so that the behaviour of primary commodities can be captured and supplemented with the data provided periodically by major manufacturing entities and service providers.
This should help the Government in effective price management.
(V. Shunmugam is Chief Economist and D.G. Prasad is an Economist with the Multi-Commodity Exchange, Mumbai. Their views are personal. The authors can be reached at v.shunmugam@mcxindia.com)