Measurement of Inflation in India

Issues and associated challenges for the conduct of monetary policy...

What is inflation?
Inflation rate is the rate at which prices of goods and services increase in its economy. It is an indication of the rise in the general level of prices over time. A sample set or a basket of goods and services is used to get an indicative figure of the change in prices, which we call the inflation rate.

Price Index
A price index is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time.
Price Indices

WPI

Industrial workers Urban non-manual Agricultural Labour Rural Labour

CPI

Wholesale Price Index(WPI)

WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy.

Consumer Price Index(CPI)

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

Difference between WPI and CPI

WPI CPI Measure the temporal price change of Measures the average price of wholesale transactions of all consumer goods and services commodities in the country purchased by households The weights of items have been assigned in proportion to their share in the total value of transaction(output) in the economy Weights are assigned in proportion to their share in the consumption expenditure of the family of industrial workers in the selected centers

Measures inflation at each stage of production

Does not include the services being offered

Measures inflation only at final stage of production

Includes the services being offered

Laspeyres Index
The Laspeyres price index is an index formula used in price statistics for measuring the price development of the basket of goods and services consumed in the base period. The question it answers is how much a basket that consumers bought in the base period would cost in the current period. It is defined as a fixed-weight, or fixed-basket, index that uses the basket of goods and services and their weights from the base period.

Substitution Bias of Laspeyres Index

Unfortunately, Laspeyres does not take into account that as prices increase the consumer will usually buy less of the product, or purchase a cheaper product, in either case reducing the sales volume of the original product. As a result of this oversight, Laspeyres index systematically overstates inflation.

Calculation of Laspeyres Index

Year 2007 2008 Quantity 1 100 200 Price 1 $1.00 $1.25 Quantity 2 50 75 Price 2 $5.00 $6.00

Enter values into the following formula: Laspeyres = 100 *(cost of base year basket in 2008/cost of base year basket in 2007). Laspeyres = 100 * ((100 * $1.25 + 50 * $6.00) / (100 * $1.00 + 50 * $5.00)) Perform the calculations. Laspeyres = 100 * ((200 * $1.25 + 75 * $6.00) / (100 * $1.00 + 50 * $5.00)) Laspeyres = 100 *((250 + 450) / (100 + 250)) Laspeyres = 100 * (700/350) Laspeyres = 100 * 2 Laspeyres = 200

Trends in CPI & WPI

Differ in terms of their weighting pattern
CPIs lag behind WPI by a month Price of services Metals and alloys

Monthly WPI and CPI

Month january 2010 february 2010 march 2010 april 2010 may 2010 june 2010 july 2010 august 2010 september 2010 october 2010 november 2010 december 2010 january 2011 february 2011 march 2011 april 2011 may 2011 june 2011 july 2011 august 2011 WPI (Base Year 2004-05 = 100) 135.2 135.2 136.3 138.6 139.1 139.8 141 141.1 142 142.9 143.8 146 148 148.1 149.5 152.1 152.4 153.1 154.2 154.9 CPI (Base Year 2001=100) 148.04 146.32 146.32 146.32 148.04 149.76 153.21 153.21 154.07 155.79 156.65 159.23 161.81 159.23 159.23 160.09 160.95 162.68 166.12 166.98

Monthly Values of WPI and CPI

180
170

160

150

140 WPI

130

CPI

120

110

100

Monthly values
Month
january 2010 february 2010 march 2010 april 2010 may 2010 june 2010 july 2010 august 2010 september 2010 october 2010 november 2010 december 2010 january 2011 february 2011 march 2011

CPI-IW (Base Year 2001=100)

172 170 170 170 172 174 178 178 179 181 182 185

CPI-AL (Base : CPI1986-87= 100)

542 538 536 538 540 547 554 557 562 566 570 581

CPI-UNME (Base : CPI1984-85= 100)

671 666 663 667 672 679 696 696 701 705 710 719

CPI-RL (Base : CPI1986-87= 100)

542 538 536 538 540 547 554 557 562 565 569 580

188
185 185 186 187 189 193 194

589
584 585 587 592 598 604 610

588
584 584 587 592 597 604 610

april 2011
may 2011 june 2011 july 2011 august 2011

Monthly values of each CPI and WPI

700

600

500 WPI 400 CPI-IW CPI_AL CPI-UNME 300 CPI_RL

200

100

Comparison of weights of some important commodities in WPI and CPI

Commodities Food Articles Minerals Fuel & Power 18.4 1.52 14.91 Wgt. in WPI 47.58 9.49 Wgt. in CPI

The graphs show a diverging trend between the WPI and CPI in short run. This is due to difference in weightages given to different commodities like Food articles, Minerals, metals & Alloys and Fuel and Power in the two indexes as shown above in the table. Services which form a significant proportion in consumption of Indian consumers, are not included in WPI whereas they are included in CPI. Because of greater services such as transportation, packaging, home delivery, cleaning etc getting embedded into retail and wholesale prices, the two indexes differ.

CPI is the preferred measure worldwide but India uses WPI

Available for all commodities and for major groups, sub-groups and individual commodities Available at high frequency WPI inflation at fortnightly lag vs CPI inflation at monthly lag. Then two components of WPI are released on a weekly basis giving weekly information on inflation trends

CRITICISM FOR WPI

INCOMPLETE PRODUCT COMPOSITION/ COVERAGE Non-inclusion of services Following a fixed weighting scheme while the economy is undergoing major structural changes Use of gross transactions data and wholesale data rather than data on final purchases FREQUENCY OF REPORTING OUTDATED BASE YEAR

COMPOSITION/ COVERAGE (1/2)

Non-Inclusion of Services
WPI does not capture price movement in services sector which has a larger and increasing share of GDP Practical problems in including services in WPI calculation: 1. Availability of data on different services sectors on a continuous basis 2. Identifying services purchased by producers and services purchased by consumers 3. Need for mixing and matching data collected from administered prices as well as from market prices for services rendered 4. Problem of non-tradable services

Following a fixed weighting scheme

Many commodities included in the Index have ceased to be important from the consumption point of view Weights and commodity baskets should be reviewed from time to time- if this is not done properly and periodically, the WPI number may not be a true representation of the inflation

COMPOSITION/ COVERAGE (2/2)

USE OF WHOLESALE DATA
Use of gross transactions data and wholesale data rather than data on final purchases Does not properly measure the exact price rise an end consumer will experience 157 countries out of 181 countries in the IMF statistics use CPI for tracking inflation (Economic Survey 2008-2009) Concept of wholesale price is not clearly defined In many cases, these prices correspond to farm-gate, factory-gate or mine-head prices In other cases they refer to prices at the level of primary markets, secondary markets or other wholesale or retail markets

FREQUENCY OF REPORTING
Question - changing the frequency of WPI series to monthly from the weekly system Currently, a large percentage of items are not reported and thus, DIPP repeats the figures of the previous week Thus, when inflation is rising, items are under-reported and when inflation is falling, items are over-reported

BASE YEAR EFFECT

Base year has considerable influence on the movement of price relatives of the individual commodities and also on the weighting pattern Seven revisions have taken place introducing the new base years, viz., 1948-49, 1952-53, 1961-62, 1970-71, 1981-82, 1993-94 and 2004-05

Criteria for selecting base year

NORMAL YEAR: stable year in respect of economic activities like production, trade, etc and their prices. It should not suffer from business cycles DATA AVAILABILITY: Reliable price data must be reasonably available for the selected base year, RECENCY: Should be as recent as possible so that by the time revised series of items and their prices are released, it should not have outlived its utility, and NOT OFF THE MARK: Base year for closely related economic indicators should not be widely off the mark

To capture the recent changes in industrial structure on account of liberalization and globalization, there is a need to have periodic revisions of WPI numbers, preferably every five years but not later than ten years. The proposed revision should bring base years of WPI and CPI numbers much closer to each other.

REVISIONS IN 2010
2004-05 as base instead of the earlier base of 1993-94 676 items as against 435 items in the previous series Consumer items widely used by the middle class like ice-cream, mineral water, flowers, microwave oven, washing machine, gold and silver are reflected in the new series of WPI Change in weights: Under primary article group of the new WPI, there are 102 items against existing 98, fuel and power category will remain static at 19 while 555 items of manufactured products will be included now compared to 318 items earlier Weight of manufactured products went up to 64.97% compared to 63.75%, while that of primary articles group, including food, came down to 20.12%, against 22.02% earlier

REVISIONS IN 2010 - IMPACT

Change of weight from 1993-94 to 2004-05 does not significantly alter the trends in overall inflation However, inflation based on the new weights exhibit greater volatility than the existing series During the first half of 2008-09 fuel and metal prices (which have higher weights in the constructed index) increased substantially on account of the sharp increases in global prices and declined sharply during the second half Greater volatility in the two broad groups explains the differences in inflation as per the new weights

What is the inflation rate we keep reading about?

It is the annual point-to-point inflation rate, which measures the change in the level of a price index over a full year Let us say that we have WPI for the beginning and the end of year: Inflation rate for the year will be = (WPI of end of year WPI of beginning of year)/WPI of beginning of year x 100 For example, Say, WPI on Jan 1st 2010 is 108.33 WPI on Jan 1st 2011 is 112.33 Therefore, inflation rate for the year 2011 = (112.33 108.33)/108.33 x 100 = 3.69% That is to say that the inflation rate for the year 2011 is 3.69%

Calculation of Index and Inflation (1/3)

It is calculated on the principle of weighted arithmetic mean, according to the Lasperyres formula which has a fixed base-year weighing diagram operative through the entire life span of the series

Where, I = Index Number of wholesale prices of a sub-group/group/major group/all commodities Wi: The weight assigned to the ith item/sub-group/group/major group Ii: Index of ith item/subgroup/group/major group The WPI Index is composed of three broad heads namely Manufactured Products, Primary Articles and Fuel Groups with weight 63.75%, 22.02% and 14.23% respectively Let us examine the detailed breakup of the Fuel Groups along with the indexed prices of each of the sub heads:

Calculation of Index and Inflation (2/3)

Thus the fuel groups index stands at: = 1597.38/14.23 = 38.74 Similarly the primary articles and the manufactured products index can be calculated and let us take their values as 29.78 and 46.35 respectively Thus, for week x in the year 20x1, WPI index = Mfg. prod. Index + Primary articles Index + Fuel Groups index = 46.35 + 29.78 + 38.74 = 114.87

Similarly, in week x of the next year, 20x2: Fuel groups index value is 1614.73/41.2 = 39.16 Corresponding value for the primary articles and manufactured products is at 32.63 and 46.63 respectively

Calculation of Index and Inflation (3/3)

Thus the value of WPI index is at the end of week x stands at 39.16 + 46.63 + 32.63 = 118.42 Thus the Index has grown by (118.42 - 114.87 )/ 114.87 = 3.09% in week x of the year 20x2 compared to its value in week x of the year 20x1 This signifies a growth in the wholesale price in India For the week ended x of the year 20x2, the inflation rate in India is at 3.09%

Problems with point-to-point inflation

Point-to-point inflation rate reflects only the difference in prices over two specific weeks. Hence, if the inflation rate moves up from one week to the next, It need not mean that prices have actually moved over that period It may equally be because there was a fall in the corresponding period of the previous year.

Which Measure of Inflation for Monetary Policy?

For the purpose of targeting of the inflation objective there is a debate on which measure of inflation to use and the broad options include, year on year changes in price indices, seasonally adjusted month over month changes, targeting the core component of inflation i.e. eliminating the volatile components from headline inflation.

Year-on-year Inflation and Month-overmonth (m-o-m) Seasonally Adjusted Inflation

WPI and Alternate Measures of Core Inflation

Core Inflation
Core inflation is a measure of inflation which excludes certain items that face volatile price movements, notably food and oil Core inflation by eliminating the volatile components from the headline helps in identifying the underlying trend in headline inflation and is believed to predict future inflation better

India: Headline Vs Core Inflation

Volatility in Inflation Measures

Which is a better measure: Core inflation or Headline inflation

Indian inflation path has been significantly conditioned by two major supply shocks, i.e., oil and food. Even the exclusion of these two items, representing the most conventional measure of core inflation, does not impart greater stability to the inflation path. Also, such exclusion makes the core measure much less representative, since the common man is primarily affected by food and fuel inflation.

Which is a better measure: Core inflation or Headline inflation

Looking at it from a different perspective: The question should not be whether I buy food and oil, but whether headline or core inflation is a better measure of where headline inflation is likely to settle once overall prices have adjusted to the higher prices of energy and food. For forecasting purposes, we want to know not only what (headline) inflation is today, but also, and much more importantly, where headline inflation is likely to be tomorrow (the medium term). Identifying a measure of underlying inflation gives us a good head start...

Effects of high Inflation rates

Increasing inflation usually denotes slowing of economy as prices for food, commodities and services rise and the currency weakens. Some of the most prominent effects of inflation are:

Increase in costs Loans becoming costlier Decrease in returns from investments Decrease in total portfolio value High taxes Cut down in working costs by companies Slow infrastructure growth