Inflation

What is Inflation? Discuss major inflation measures taken by RBI?

Prices of specific goods or services may go up or down relative to the prices of others reflecting changes in productivity or demand and supply conditions. But when the overall price level rises, it erodes the purchasing power of income, raises the cost of living and lowers the real value of savings. Savers, investors and financial intermediaries track closely the link between inflation and interest rate. The level of inflation is also critical in terms of maintaining competitiveness of domestic industry in a liberalised trading and market determined exchange rate regime.  More importantly, it is the poor who are most vulnerable to inflation as they do not have any effective hedge against inflation. As Keynes said, "Inflation is the form of taxation which the public find hardest to evade." Thus, the issue of inflation and its measurement have always received lot of attention in India.

Major inflation measures taken by RBI:

India has a rich tradition of collection and dissemination of price statistics dating back to 1861 when the Index of Indian Prices was released.  

Currently, there are five different primary measures of inflation - the Wholesale Price Index (WPI) and four measures of the Consumer Price Index (CPI). 

 In addition, Gross Domestic Product (GDP) deflator and Private Final Consumption Expenditure (PFCE) deflator from the National Accounts Statistics (NAS) provide implicit economy-wide inflation estimate. 

 The WPI is considered as the headline inflation measure because of its availability at high frequency until recently, national coverage and availability of disaggregated data which facilitate better analysis of inflation.

     While the WPI does not cover prices of services, CPIs are meant to reflect the cost of living conditions for a homogeneous group of consumers based on retail prices.  Among the four measures of CPI, the CPI for Industrial workers (IW) has a broader coverage than the others - the CPI for agricultural labourers (AL), rural labourers (RL) and urban non-manual employees (UNME).  In the organised sector, CPI-IW is used as a cost of living index.

    GDP Deflator, on the other hand, is a comprehensive measure of inflation, implicitly derived from national accounts data as a ratio of GDP at current prices to constant prices. While it encompasses the entire spectrum of economic activities including services, it is available on a quarterly basis with a lag of two months since 1996.  Moreover, national income aggregates extensively use WPI for deflating nominal price estimates to derive real price estimates.

      Even as each of the measures has its strengths and weaknesses, the selected measure of inflation should broadly capture the interplay of effective demand and supply in the economy at frequent intervals. However, the trend in various measures of inflation during the recent years has raised several conceptual measurement issues of inflation.

 First, the divergence between WPI inflation and CPI inflation has widened. 

Second, the representativeness of WPI has reduced as it does not capture the price movement in the services sector which has a larger and increasing share of GDP - about 65 per cent in 2008-09.

 Third, old base periods - for WPI (1993-94), CPI-UNME (1984-85), CPI-RL (1986-87), CPI-AL (1986-87) and CPI-IW (2001) - fail to capture the rapid structural changes in the economy. 

Divergence between WPI and CPI 

  Why do WPI and CPIs differ?  They differ in terms of their weighting pattern. First, food has a larger weight in CPI ranging from 46 per cent in CPI-IW to 69 per cent in CPI-AL whereas it has a weight of only 27 per cent in WPI. The CPIs are, therefore, more sensitive to changes in prices of food items. Second, the fuel group has a much higher weight in the WPI (14.2 per cent) than the CPIs (5.5 to 8.4 per cent). As a result, movement in international crude prices has a greater bearing on WPI than on the CPIs. Third, services are not covered under WPI while they are, to different degrees, covered under CPIs. Consequently, service price inflation has a greater influence on CPIs.