Between ‘Aam Aadmi’ and WPI

V. Shunmugam
Recent efforts of the print and electronic media to unplug the current zero level inflation as calculated from the recently released WPI from the increasing price trends at the retail level ended up confusing the ‘common man’ rather than clarifying it. Should he be happy about the near-zero level inflation numbers as revealed from the recently released WPI numbers or should he worry about stiff or increasing prices of commodities purchased by him from the next door Kirana shop? The simple fact that the a stubborn CPI and falling WPI had been existing together for the previous long six months leaves one wondering what the recently announced inflation number means to the ‘common man’. Below is an attempt to compare and distinguish underlying currents in the WPI and its relevance to him.

Fundamentally, WPI remains an attempt to index the prices of about 435 commodities collected at the wholesale level and compiled by the OoEA/Ministry of Commerce and Industry and to calculate the extent of price movement on a year over year (YOY) basis. To filter out the seasonal effects that the fundamentals of the different commodities in the WPI basket might have, YOY calculation has been done to measure inflation or the price change. Hence one has to remember that the inflation numbers calculated based on WPI is only a relative number based on the year ago price level and any lower inflation does not mean that prices have reversed but that the rate of price increase had declined. Further, of the 435 commodities represented in computation of WPI Index only about 77 i.e. 18 percent refers to commodities that can be associated with immediate consumption by the common man which has a combined weight of 21.54 percent. Tracking the movement of WPI, it is natural that the price increase which common man sees in many of the commodities of his frequent consumption is likely to remain higher 4.26 percent at the whole sale level. Though appropriateness of the commodities and their weights remains debatable, to preempt the same, authorities should consider conducting expenditure surveys on a frequent basis (as is the case with the United States) or atleast expanding the scope of the NSSO annual surveys to include WPI related commodities as well to make it reflect ground realities more frequently. It would ensure that policies taken to contain inflation yield intended results.

Rest of the commodities undergo industrial processing/value addition before being consumed by consumers directly or indirectly (services/manufactured goods) and can be grouped into three depending on their consumption availability over a short/medium/long period in time. Among them the first group of commodities gets value added and is available for direct or indirect consumption of our common man in a short period in time. This group would have an immediate term impact on the price levels for the common man if not at the same interval as that of the earlier discussed group of commodities. As per the existing WPI basket, it would approximately account for only about 26 percent of total consumption basket of our ‘common man’. With a 1.56 percent increase in WPI and given its weightage of 31.48 percent, the change in the WPI number would take a short period in time to get reflected on prices of the ‘commodities or services’ that our common man would consume. The second class of industrial commodities (7 percent with 6.19 weight in WPI) would take a slightly longer time (6-12 months) to impact the overall price levels or somewhat indirectly reach our ‘common man’. The last group of commodities which represents about xx percent of the kitty had undergone a price change of 49 percent as per the WPI weightage (40.79 percent) but would take more than an year’s time to get reflected in the price of goods and services that our common man witnesses in his neighborhood. Overall, what he sees in WPI will not be what he would get in his kirana shop or would have an impact on the common services that he consumes due to several reasons.

Firstly, WPI is a reflection of prices that exist at the wholesale markets and there exists a long value chain mired in opaque markets which add to its margins often to mark themselves to what our common man sees as inflation at the whole sale level. Reforms in the value chain connecting producers with consumers and increasing market transparency would help in transferring the benefit of lower increase in WPI into CPI in all groups of commodities, more so in the case of first group of commodities which are closer to our common man. Secondly, given the current high volatility in forex rates (11%), equities (46%), interest rates (24%), and commodities (26%), value addition becomes a costlier process due to high cost of risk management which gets passed on to the consumers reflected in increased prices of processed/value-added products. It essentially leads into price-wage loop as it happened in the previous boom, breaking which would need demand shrinkage that has the potential to lead to an unemployment spiral. Existence of derivative markets in the above asset classes with public and private participation bringing in heterogeneity would help not only help corporates to manage their risks effectively but also acts as the conduit for masses and public institutions to express their price expectations for natural or policy enabled smoother adjustment in demand and supply. Thirdly, existence of an effective competition policy and strict monitoring would help avoid collusion among few industries within a given sector thus preventing higher markups in value added commodities. Though the laundry list of inefficiencies in markets, manufacturers, and service providers is infinite, the first three here are obvious. It will be a combination of policy, institutional, and regulatory reforms that would help shrink the spread between the WPI and CPI. Till then for our common man, it will be not what he sees on the media as inflation or somewhere closer to it that he would get in his neighborhood. After all, there is a reason for the Public Lending Rate of the Commercial banks (12.25%) to remain higher than the RBI’s lending rate to the commercial banks (reverse repo rate – 3.5 %)!

USING FUTURES TO CONTROL INFLATIONARY PRESSURES
COMMENTARY - BEHAVIOURAL ECONOMICS

V SHUNMUGAM
Jun 03, 2008
http://staging.livemint.com/2008/06/02215059/Using-futures-to-control-infla.html?d=1
A well-known oncologist in Chennai who recently operated upon a relative to remove a cancerous growth alerted the latter’s son during the pre-surgery consultation against speaking to the patient about the surgery to shield him from panicking. The idea was to accelerate recovery and avoid post-operative complications.

The medical metaphor illustrates how inflation can be compared with cancerous growth to emphasize the crucial role of behavioural sciences in inflation management.

Cancer is an excessive growth of cells, and inflation is a flare-up in the prices of items of common consumption that make them inaccessible to a larger section of population.

So, the behaviour of the stakeholders should be managed better for any anti-inflationary measure to succeed.

Inflation, a function of prices themselves, is the net result of perceptions of the market participants about the value of a commodity based on its supply and demand and their reactions to it. Behavioural sciences come into the picture the moment the market reacts to demand exceeding supply estimates, or to short supply.

Perceptions about stocks of commodities are another key factor. Strengthening long-term stocks, essentially by using a long-term tool to curb short-term volatilities, is the solution. However, identifying the nature of stocks, whether public stocks or private hoarding (a short-term tool traders use to create volatility in the markets and benefit from it) is a challenge.

The behavioural theory also stresses that economic stakeholders react bullishly to perceived price hikes stoking it further. The reaction hap pens at multiple levels—at the individual, social-group and political economy levels.

At the individual level, a perceived price rise would lead us to the theory of inflationary expectations as propounded by J.M. Keynes during the early 20th century. Individuals with varied objectives would purchase and store commodities of consumption, trade and production. An individual consumer may tend to stock, at least for the short term, creating a short-term scarcity and, hence, a further price rise. Or, in anticipation of a price hike, they may demand higher wages, again leading to a further price increase. Producers or traders would always store and sell in a market where prices are expected to move up.

In the midst of all these rational choices, the question is: can this be prevented through micro-management? The cost of micro-management would be higher than the benefits it provides, and an inefficient bureaucracy would muck it up. Therefore, the solution would be to have an advance indicator of price rises and their origins, so that the root causes can be better addressed.

It is to prevent inflation from occurring rather than trying to cure it after it starts moving up.

There are many devices to gauge inflation expectations, including forecasts by renowned institutions, and individual analysts and economists, information emanating from the financial markets (debt markets, for example), and information flowing from trading of commodity futures and indices on the exchange platforms, to help policymakers take better preventive measures.

Indeed, commodities are the root cause of inflation in any economy and, hence, we looked at the possibility of Multi Commodity Exchange of India Ltd (MCX) commodity futures having indicated the high price rise that could happen in April 2008 (through the prices of April maturity contracts) about two months ago, in February 2008.

The April prices of these commodities had indicated an expectation of 7.7% price rise after adjusting for the carrying costs two months ago. Though the selected commodities constitute only about 2% of the gross weights of the Wholesale Price Index, the futures markets had already indicated a possible price rise in those commodities.

These futures, being individual in nature and unlike any other composite indicators, can make the policymakers’ task of targeting price-control measures more effective, and controlling the inflationary pressures at their very origins, better. In fact, futures prices discount the best possible information about relevant domestic and international fundamentals, policy decisions, and market sentiments.

If these price signals can help the market stakeholders to take effective production, consumption and marketing decisions, why not the country’s economic managers?

Traders or producers would stock commodities in a rising market, and this tendency would increase with increase in market volatility, particularly in a northbound market.

Again, price volatility is inversely related to the transparency in information about the price-moving factors.

Thus, in a way, the producer is paid only for the real scarcity of the produce and not for lack of information about it. Healthy futures market trading would help bring in transparency in the market and prevent inordinate price movements as well as hoarding.

It is necessary for the government or the managers of the political economy to get price signals in advance, so that they can better plan inflation management in such a way that the stakeholders in the economy do not know about them and hence, do not react irrationally.

The commodity futures market can definitely provide clues well in advance and, thus, help policymakers deal with the behaviour of individuals and groups, as well as the markets in which they participate, and hence, the economy.

The author is chief economist at the Multi Commodity Exchange of India Ltd. These are his personal views and do not reflect those of the exchange.

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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)