Inflation and its Index

demystified!!
Terminologies
Inflation is defined as a sustained increase in the general level of prices for
goods and services. It is measured as an annual percentage increase. As
inflation rises, every dollar you own buys a smaller percentage of a good or
service.
There are several variations on inflation:

Deflation is when the general level of prices is falling. This is the

opposite of inflation.

Hyper-Inflation is unusually rapid inflation. In extreme cases, this can

lead to the breakdown of a nation's monetary system. One of the most
notable examples of hyperinflation occurred in Germany in 1923, when
prices rose 2,500% in one month!

Stagflation is the combination of high unemployment and economic

stagnation with inflation. This happened in industrialized countries
during the 1970s, when a bad economy was combined
with OPEC raising oil prices.

Wholesale price index (WPI) is an inflation index which takes into account
goods and services at the seller level. This has higher weightage of goods
and services which affect the macro economy while a lesser part of it is
constituted by fuel and food prices.
Consumer price index (CPI) takes into account inflation in goods which
affect a household and hence food and fuel prices have a more prominent
weightage given in this index.
Why do we need to compute inflation for RBI policies?
Most of us have heard of monetary policy but are not quite sure what it
means and what it affects. The thing we need to understand about monetary
policy is that it controls the supply of money in the economy. Simply put, it
controls how much money is flowing into the system. There are some very
interesting tools available with the RBI that help it to achieve this, including
interest rates, cash reserve ratio, statutory liquidity ratio etc.
When RBI controls the supply of money, it has a widespread effect. When the
money flow increases, more people have extra money which they spend on

buying stuff. As a result of this, the demand increases which thereby

translates into inflation. However, if the inflation rises too much, the RBI
might want to retrace it's steps and again control the supply of money.
Therefore, inflation is like an end result for RBI's actions. It determines
whether the controls have worked or whether RBI needs to tweak the levers
more. Inflation is like a feedback for the RBI.

Which measure of inflation is closer to reality?

Simply speaking, the WPI inflation talks about prices of various products in
the wholesale market. On the other hand, the CPI inflation talks about prices
of products in the retail market. A layman would think that CPI is obviously
closer to the reality - because that's the inflation which the real consumer has
to actually face in the market. That layman wouldn't be wrong.
But there is a reason why WPI was actually preferred over CPI. The thing
about WPI is that it gives a more accurate feedback, and it gives a
more quick feedback. There you have it - accuracy and quickness.
This is because it does not take much time for price changes to pass on to
the wholesale market. However, it takes time for those effects to trickle down
to the retail market. As a result, retail market will reflect those changes over
a longer period of time, as a result of which CPI wouldn't be as reliable.
But then again, let us remember that we are not talking about accuracy
or speed, we are talking about relevance. It does not matter if I have the
data very fast if that data isn't relevant at all! There are certain reasons why
CPI is more relevant that the WPI

It shows the actual cash flow on the side of the final consumer
CPI takes into account all the economic realities, including the
taxes and profits of all the middlemen
This measure of inflation takes into account services as well
CPI takes into account the behaviour of wholesalers when it comes
to passing on the price changes to the consumer. This means a
more accurate and predictable action plan over time.
Primarily due to these reasons, it makes sense for RBI to take the CPI inflation
into account while deciding upon the policy changes. RBI has started this
practice since about a couple of years, because we also have a better way of
computing the CPI inflation these days.
Why RBI shifted to CPI over WPI?

Now, we have one representative measure of retail inflation with

further disaggregation to see how prices in rural and urban India
are changing.
We also have CPI monthly inflation data released couple of days
prior to WPI inflation data for the same month.
Apart from these reasons, WPI excludes prices of services such as
education, healthcare, and rents which account for nearly 60 per
cent of GDP. As a result, inflation in these services is largely
determined by the domestic demand-supply situation. The new CPI
measure assigns nearly 36%weightage on services and includes
price changes in housing, education, healthcare, transport and
communication, personal care and entertainment. CPI, therefore, is
a better reflector of demand side pressures in the economy, than
wholesale prices.
WPI assigns nearly 15% and 10.7% weightage for the fuel group
and metal and metal products group, respectively. Any sharp
movements in international prices of fuels and metals lead to sharp
changes in WPI which make it difficult to gauge the underlying
inflationary pressures.
Retail inflation is an indicator of the underlying demand situation in
the economy. In a strong demand environment, retailers pass on
the entire increase in wholesale prices or even more to their endconsumers, if demand remains weak, retailers witness pressure on
margins.
Another proposal to change the weightage for food in CPI to
prevent the seasonal effects to create sharp changes on the
monetary policy.
But theres a crucial additional wrinkle: In India, food prices simply
dont respond to monetary policy. The central bank has known this
for a while, pointing out that food prices are driven by supply-side
factors such as poor infrastructure in Indias vast rural hinterland
and regulations that make it hard for farmers to sell their produce
directly. Fixing food inflation in India requires extensive agricultural
reformsnone of which have really been top priority for the
government.
Even if the RBI trusts the brand-new consumer price index more
than Indias worryingly limited and outdated wholesale price index,
it should at least consider taking foodand perhaps fuel prices,
which are also difficult for Indian authorities to controlout of the
equation. In other words, it needs to target core consumer
inflation.

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