Updated: Nov 9, 2019
In India inflation is measured with the help of two major indices i.e. WPI-Wholesale Price Index and the Consumer Price Index. These indices indicate the total change in the price level that is paid either by the consumer or the producer. Prior to 2016, the monetary policy committee of the RBI used to monitor the WPI for the purpose of making changes in the monetary policy. Post 2016, when Mr Raghuram Rajan took over as the governor of the RBI, the apex bank started monitoring the CPI. This was done as the CPI better captures the change in the price levels of those goods that directly affects the final consumer.
WPI vs CPI
WPI index reflects average price changes of goods that are bought and sold in the wholesale market. The various commodities taken into consideration for computing the WPI can be categorised into primary article, fuel and power, and manufactured goods. Primary articles included for the computation of WPI include food articles, non-food articles and minerals. In the fuel, power, light and lubricants, electricity, coal mining and mineral oil are included. The manufactured goods category encompasses food products; beverages, tobacco, and tobacco products; wood and wood products, textiles; paper and paper products; basic metals and alloys; rubber and rubber products and many others.
In contrast, CPI is computed by executing a weighted average on a particular set of goods and services that are acquired by household for general consumption such as food, telecom, transportation, medical care amongst many others. The computation of CPI takes into account price changes and the actual inflation that affects the end consumer.
The WPI does not include any changes in the price of services and also it does not indicate the actual burden borne by the final consumer as the price level changes are at the wholesale level as compared to CPI which measures the prices at the retail level.
Current inflation trends
In September 2019, the retail inflation which is measured by the Consumer Price Index rose to 3.99% which is close the to the medium term target of 4% set by the RBI for the first time in 14 months. Inflation in August was at 3.21%.
Rise in price levels of food items was the major driver of the increase in the retail inflation level. Food and beverages account for about 54% of the CPI index. The CPI food inflation had increased to 5.11% in September as compared to 2.99% in August. Within food items as well , vegetable prices increased the most to 15.4% from 6.9% in the previous month and within vegetables onions saw the maximum price increase as their inflation rate reached 66.38% from 6.37%.
Even though the retail inflation reached its highest levels, wholesale inflation measures by the WPI index fell to its 39 month low of 0.33% compared to 1.08% in August. This fall was majorly driven by the lack of pricing power with the producers. Since the economy is slowing down, and there is a depressed demand in both the consumer durables and consumer non- durables, producers have not been able to raise prices and they have to offer heavy discounts to clear the inventory which can be seen in the automobile industry.
Diverging CPI and WPI
Over the past few months, the gap between the CPI and WPI has been widening due to the difference in composition of the two index. Manufactured items have the highest weight of 64.23% in WPI, while fuel and primary articles have 13.15% and 22.62% weight, respectively. Food and beverages have the highest weight of 54.18% in CPI, while services sectors such as health, education and amusement have a combined weight of 27.26%.
Vegetable and Pulses have contributed around 76.4% to the increase in the retail inflation and it is expected that the food prices will remain high till March 2020 because of draught in some regions and excessive rainfall in the other regions leading to shortfall in the overall supply. In both the CPI and WPI, fuel and light manufactured items saw a decline in the price levels because of international factors and subdued demand. The deflation rate in CPI ,rose to 2.18 per cent in September from 1.70 per cent in the previous month.
Possibility of another rate cut?
The RBI has already reduced the repo rate by 135 bps and it is expected by various analysts that there will be a rate cut for the sixth consecutive time in December as the slowdown still continues in the economy as seen by the falling WPI and even the retail inflation is within the medium term target of RBI. Even though the retail inflation has increased, but the increase in price of vegetables and pulses is temporary and will only last till March 2020. Also, the core inflation which does not include fuel or food was about 4.2% in September as compared to 4.25% in August, a 26 month low.
Headline and Core Inflation
Headline inflation is the raw inflation figure as reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics. The CPI calculates the cost to purchase a fixed basket of goods, as a way of determining how much inflation is occurring in the broad economy. The CPI uses a base year and indexes the current year's prices according to the base year's values.
Core inflation removes the CPI components that can exhibit large amounts of volatility from month to month, which can cause unwanted distortion to the headline figure. The most commonly removed factors are those relating to the cost of food and energy. Food prices can be affected by factors outside of those attributed to the economy, such as environmental shifts that cause issues in the growth of crops. Energy costs, such as oil production, can be affected by forces outside of traditional supply and demand, such as political dissent.
Role of core and headline inflation in monetary policy making?
In the RBI’s newly adopted flexible inflation-targeting framework, the headline CPI inflation measure is being used as the target rate of inflation as it reflects the prices of essential consumption goods.
To achieve the medium- to long-term goal of controlling headline inflation, the RBI is trying to look beyond it. Even though the headline CPI (consumer price index) inflation is moderating, the monetary policy committee (MPC) cited concerns about sticky core CPI inflation. It is therefore essential to analyse the role of headline against core inflation in fixing the policy stance.
The headline inflation measure demonstrates overall inflation in the economy. Conversely, the core inflation measure strips the prices of highly volatile food and fuel components to distinguish the inflation signal from transitory noise. The inflation process in India is dominated to a great extent by supply shocks. The supply shocks (e.g., rainfall, oil price shocks, etc.) are transitory in nature and hence produce only temporary movements in relative prices. The headline CPI inflation in India tends to increase whenever there is a surge in food and fuel prices. Since monetary policy is a tool to manage aggregate demand pressures, the response of the policy to such temporary shocks is least warranted according to traditional wisdom.
This is because the monetary policy affects output and inflation with a lag. Hence, the impact of monetary policy action today in response to a supply shock would materialize only some quarters later, when the temporary shock to prices would already have been reversed. However, in such a scenario, if the temporary supply shocks produce strong second-round effects, the policy response is warranted.
Conversely, core inflation excludes the highly volatile food and fuel components and therefore represents the underlying trend inflation. The trend inflation drives the future path of overall inflation. Hence, even when food and fuel inflation moderates over time, persistently high inflation in non-food, non-fuel components poses an upward risk to overall future inflation, creating challenges to monetary policy.
The RBI faced a similar challenge in fixing the policy stance recently. Headline inflation in India slowed to 3.17% in January 2017 on the back of a sharp fall in food prices such as those of vegetables and pulses. Conversely, core inflation remained sticky around 5% due to inflation in the services component, mainly transport and telecommunication.
Why is core inflation so important in deciding policy stance? Since it represents the underlying inflation trend, high core inflation today carries the seeds of high future inflation. Also, as long as temporary supply shocks fail to bring about changes in the underlying trend (core) inflation, headline inflation will revert to core inflation. This is the desirable outcome from the policy perspective.
However, shocks to headline inflation such as food and fuel price shocks, if they persist for a longer period of time, would feed into the higher long-term inflation expectations of people, generating substantial second-round effects. When this occurs, core inflation would revert to headline inflation, posing challenges to monetary policy. We cannot deny the presence of strong second-round effects of supply shocks pushing up core CPI inflation in India. The critical role of monetary policy, then, is to block the second-round effects of supply shocks by anchoring long-term inflation expectations. However, the task of anchoring inflation expectations depends on the credibility of the central bank, established through its commitment towards medium- to long-run inflation targets. With high credibility and well-anchored inflation expectations, low and stable inflation can be achieved even when the headline inflation increases due to relative price changes.
To sum up, price stability implies control of overall inflation. The medium- to long-term goal of monetary policy, therefore, should be to control headline inflation. However, core inflation is the means to achieve low and stable inflation and hence cannot be ignored completely. That is why the RBI is really trying to look beyond headline inflation.