Will the real inflation rate stand up please?

WPI inflation is highly sensitive to tradables and ignores several services, which are likely to show higher inflation, notes Rajeev Malik

One macro issue in India that deserves renewed attention is the preference for the wholesale price index over the consumer price index for tracking inflation.

Indeed, the WPI is given much greater importance than the CPI by the Reserve Bank of India for calibrating its monetary policy.

This is a serious policy faux pas.

India’s use of WPI inflation for monetary policy is in contrast to the reliance on CPI inflation by central banks and governments in other countries.

This idiosyncrasy causes a bizarre contradiction: policy makers, businesses and their lobby groups, and the business media are celebrating the significant decline in inflation, relying on WPI inflation.

This contrasts with retail inflation, which better represents the inflationary pressures experienced by households, being off the charts.

It’ll come as a rude shock to many that India’s retail inflation is the sixth highest in a ranking of 100 countries.

This is both embarrassing and worrying. Indeed, India is the only country where policy makers and most investors have been celebrating the ‘collapse’ in inflation, even though consumer inflation remains worryingly high.

There is no consistent pattern of the differential between inflation measured by the WPI and the CPI- industrial workers.

The latter was the main measure of retail inflation before the launch of a new improved CPI time series (let us label it CPI-new) in 2011.

In the seven years to 2005-06, WPI inflation averaged 4.8 per cent annually versus 3.9 per cent for CPI-IW.

However, from 2006-07 to 2012-13, CPI-IW inflation averaged 9.1 per cent annually, higher than seven per cent for WPI inflation.

In the last two or three years, both CPI-IW and WPI inflation have come off their respective peaks.

However, they moved in opposite directions in 2012-13: WPI inflation eased to 7.3 per cent, but CPI-IW rose 10.4 per cent (actual CPI-new rose 10.2 per cent).

It is important to appreciate that the WPI and the CPI are two different indices.

WPI inflation is highly sensitive to tradables and ignores several services, which are likely to show higher inflation.

In fact, the WPI is not a replacement for the CPI, irrespective of the former’s greater level of detail and timeliness.

But that is effectively what Indian policy makers have been doing in using the WPI for setting monetary policy.

There are three key differences in the composition of the sub-components of the two indices.

First, CPI-new has a much higher weight (47.6 per cent) for food ex-tobacco versus 24.3 per cent in the WPI.

Second, fuel-related category has a lower weight of 9.5 per cent in CPI-new compared to 14.9 per cent in the WPI.

Third, CPI-new includes services and housing, both of which are missing from the WPI.

On balance, CPI-new is a better representation of inflation experienced by households.

It is a myth that CPI-new inflation is higher than WPI inflation only because of the higher weight of food.

There is a significant difference in the core measure of the two indices.

Thus, while WPI-core inflation declined to 3.5 per cent year on year in March, CPI-new core inflation edged up to 8.7 per cent.

Surely, such a high level of retail core inflation also indicates entrenched underlying inflationary pressures not captured by WPI-core and, therefore, ignored by policy makers.

Headline WPI and WPI-core are significantly affected by tradables, while CPI-new is affected more by non-tradables.

Almost half of the CPI-new core inflation of 8.7 per cent year on year is from the ‘miscellaneous’ sub-category (weight of 26.3 per cent in the CPI-new basket).

This includes education, medical care, household requisites, etc, which have become more expensive.

These should be relevant for tracking retail inflationary pressures from the perspective of households’ rising incomes and affordability.

But the RBI’s mass brainwashing in favour of the WPI ignores these signals.

It is quite likely that stubbornly high consumer price inflation has also had a lasting adverse impact on inflation expectations.

The RBI often says it looks at all inflation measures.

But by announcing a formal forecast only for WPI inflation, it pretty much confirms that it cares less about retail inflation.

This preference for the WPI is also responsible for the weak fight against retail inflation.

The central bank’s approach has resulted in a perverse outcome of two perceptions of inflation.

One perception, based on the WPI, which the RBI reportedly attempts to check, shows a significant decline in inflation.

The central bank has been cutting policy rates based on the improvement shown by this indicator.

The other inflation reality, based on the CPI, is the one that households experience.

This remains stubbornly high, partly because of policy makers’ neglect.

Now, food and commodity prices affect CPI inflation in other economies as well.

But their central banks have not abandoned a formal CPI inflation forecast.

It is well known that central banks cannot directly affect food inflation with interest rate policy.

However, they cannot be oblivious of the impact of sustained high food inflation on cementing elevated inflation expectations.

In India’s case, these in turn adversely affect local deposit mobilisation and also encourage the rush for gold.

Hoarding of gold by Indian households should be seen as reverse capital flight -- fuelled by high retail inflation and its disregard by policy makers, concerns over the rupee’s outlook, and policy-related uncertainty.

In 2013-14, CPI inflation could ease, say, to 7.5 per cent to eight per cent.

But this will still be above real GDP growth for the fifth consecutive year.

It is ironic that Indian households, the key constituency that matters most for anchoring inflation expectations, do not appear to buy the inflation-has-declined-significantly mantra.

The typical narrative is that WPI-core inflation has eased because of the slump in aggregate demand.

But why hasn’t the same slump in aggregate demand impacted CPI-new core inflation?

In fact, what is so special about India that the RBI neglects high retail (and its core component) inflation?

The RBI should do some soul-searching about its own disregard of retail inflation contributing to high inflation expectations of households.

It is high time it gave explicit importance to consumer inflation by announcing a formal forecast for it.

Sustained low consumer inflation is a prerequisite for a lasting acceleration in economic growth.

The Indian economy is like a truck with a broken gearbox.

Painting the truck, changing the tyres or the driver, putting more fuel or favourable advertising campaigns won’t have a meaningful impact on moving it into higher gear on a sustained basis.

The gearbox needs to be fixed for smooth and lasting acceleration.

High retail inflation is one of the issues that have caused the transmission to be jammed.

The RBI needs to appreciate that it cannot convince households that it can successfully check or anchor something it doesn’t pay explicit attention to.

The writer is senior economist at CLSA, Singapore. These views are his own