The Telegraph
Since 1st March, 1999
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Premature panic buttons
- The government got the inflation figures slightly wrong

The government is clearly worried about inflation and inflation figures prominently in the prime minister's press conference. We are told the government will 'soon gain mastery over inflationary expectations', ascribed to increasing world oil prices, a delayed monsoon, the temporary truckers' strike and an overhang of excess liquidity. Shortly after the prime minister's assurances, we have the wholesale price index figures for the week ending August 28 and this shows an inflation rate of 8.33 per cent. At the same time last year, the inflation rate was 3.88 per cent.

In popular reaction to inflation figures, there is often some misunderstanding of what inflation is. Inflation is a phenomenon of rising prices and the inflation rate measures the rate at which prices are rising. So if the inflation rate declines, prices are still increasing, except that the rate at which prices are increasing has slowed down. Prices won't actually decline unless the inflation rate turns negative, a rare occurrence.

Once this is appreciated, we have a measurement problem. Prices of different commodities move at different rates and to make sense of what is happening to the price level in an aggregate sense, we need to sum across these individual price movements, leading to an index. In constructing this index, there are three choices, so to speak. First, what are the commodities that will be included in the basket to be aggregated' Second, what weights will be ascribed to these commodities' Third, where do I get the price data' Differing answers to these questions lead to differing indices and there are actually six different price indices. Part of the problem is that these different indices exhibit differing trends.

First, there is the WPI. The 8.33 per cent figure is according to the WPI. As the name suggests, the WPI measures inflation from the point of view of producers, gauging the impact inflation has on their input costs. Since we are interested in inflation as consumers, our interest should focus on the consumer price index. And, second, at the Central government level, there are four different CPI series ' CPI for industrial workers (CPI-IW), CPI for agricultural labourers (CPI-AL), CPI for rural labourers (CPI-RL) and CPI for urban non-manual employees (CPI-UNME). Of these, CPI-RL is rarely used. To complicate matters, state governments bring out their own CPI series. So there will be a separate CPI for Delhi or for Calcutta. Third, there is an index that is rarely used outside government and economist circles. This is known as the gross domestic product deflator, used to convert nominal GDP growth to real GDP growth.

Indeed, there are problems with these indices, as they stand. The WPI has a base year of 1993-94. CPI-IW has a base of 1982, CPI-AL and CPI-RL have bases of 1986-87 and CPI-UNME has a base of 1984-85. With old base years, the choice of commodities for inclusion in the basket of calculation becomes old and the ascribed weights are also old. Since consumption patterns change, base years should also change. In August 2001, the National Statistical Commission (chaired by C. Rangarajan) submitted a report on government statistics and this came down quite heavily on these old base years used for inflation calculations. For instance, the growth of the service sector was unanticipated at that time and the service sector is therefore under-represented in those old weights.

Accordingly, a services price index has been under construction for some time, presumably to be integrated with the WPI. Reports have also appeared that the Planning Commission now plans to construct a producer price index, with a base year of 2000-01. This will obviously replace the WPI and subsume the proposed SPI. Why the PPI has to be constructed with the World Bank's technical expertise is anyone's guess. There is no dearth of expertise within the country to construct price indices.

Reports have also appeared about the unreliability of price data. For instance, the price data for 68 commodities used in computing WPI have remained unchanged for more than 3 years. These 68 commodities account for 11.3 per cent of WPI weights and under the National Democratic Alliance government, these price data were simply not revised.

The upshot is that there are legitimate reasons for being sceptical about the quality of inflation data. But having said that, these distortions probably do not affect inflation figures that significantly. That is, even if these distortions had been corrected, the inflation figures would probably have been more or less what they are. So how serious is inflation' Is it actually 8.33 per cent'

There is a further catch. This is not only WPI, but it is WPI on the basis of what is called point-to-point. That is, this is inflation as measured by what the price level was exactly one year ago. Consequently, it becomes a function of what the price level was in 2003. If you track price behaviour in 2003, you will find prices began to increase in September 2003. In other words, because of this increase in the base, inflation as measured by point-to-point WPI will begin to slow down in September 2004. It won't be as bad as for the week ending August 28.

On an annualized basis, WPI inflation is probably running closer to between 6 and 6.5 per cent. However, one must remember that the point-to-point WPI figures issued are provisional. They are subsequently revised and final figures may differ from provisional ones. For instance, the last month for which we have the revision is June 2004 and this shows almost one percentage point difference between provisional and final figures. Stated differently, point-to-point inflation is probably worse than 8.33 per cent. Which is why annualized inflation is probably closer to 6.5 per cent than 6 per cent.

If we are interested in long-term inflation trends and not month-to-month variations, we should look at annualized WPI inflation figures. Unfortunately, these are only available subsequently. By the same token, as consumers, we should be interested in the CPI rather than the WPI. But CPI figures surface with a time lag. In contrast, point-to-point WPI figures are available almost instantaneously and grab headline space. As an example, vegetable prices will understandably have a low weight in WPI and a higher weight in CPI. We look at a vegetable price increase of almost 60 per cent and begin to disbelieve the WPI figure, even if it is 8.33 per cent. In all fairness, we should appreciate that there is much more to aggregate inflation than vegetable prices alone.

How bad is CPI inflation' Depends again on which CPI index we use. But for most of us, the relevant one is CPI-UNME and at an all-India level, this shows an inflation rate of marginally more than 3 per cent. For Calcutta, it is 3.9 per cent and while there are cities like Chandigarh and Lucknow where CPI inflation is approaching 7 per cent, there are also places like Bhopal where it is actually negative. Even if one accepts that with a time-lag, factors that led to an increase in WPI will also affect CPI, it is unlikely that CPI inflation will be more than 5 per cent.

Some factors are transitory, like the truckers' strike or the delayed monsoon. Others are more permanent, like global oil prices. Nor should one forget the budget's education cess, the hike in service sector tax and its extension to more sectors. The government obviously got the inflation figures slightly wrong. For example, inflation measured by the GDP deflator, was assumed to be between 4.5 and 5 per cent in the budget. In May 2004, the Reserve Bank of India's annual policy statement expected WPI inflation of 5 per cent. Subsequently, the RBI's annual report expects inflation to increase, without attaching precise numbers.

As a generalization, inflation is probably one percentage point higher than what the government expected it to be. So what does one do as an anti-inflationary package' Duty cuts on sugar, edible oils, petroleum products and steel. Pressure on oil companies to slash profit margins. Mop up excess liquidity through market stabilization bonds and treasury bills. And most dangerous of all, hike interest rates, the cash reserve ratio increase being a prelude. Panic buttons have been pressed too quickly.

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