The Hindu Business Line : Some questions about inflation

There is much talk of inflation but it is not understood fully, especially its measurement. For various reasons the WPI is the preferred choice, though now with services occupying an important role, inflation on this count has been rising, as in the US. If the services inflation continues to rise and the commodity prices persists at the current levels, the very notion of price stability would be called into question, says A. Vasudevan.

HEADLINES IN newspapers often exaggerate the fall or rise in the inflation rates in their weekly reporting of movements in the Wholesale Price Index (WPI). This is understandable in part because inflation in India is measured in terms of the movement in the WPI for a bundle called "all commodities". But this does not necessarily mean that changes in the WPI correctly measure the prices that consumers pay for the commodities they consume.

Official quotations of prices of pre-determined varieties of products drawn from given markets rarely show volatility. If the varieties in any product were not much in use because of the availability of improved products in markets that are outside the official scan for purposes of compilation of the index, the official quotes would be more or less constant till the new index is constructed.

Besides, the emergence of substitute products or varieties of products resulting from technological innovations could moderate the movements in the official quotations that enter the exercise of index construction.

These limitations, however, would exist in any index construction. But what is surprising is that most Indian economists, past and present, have tended to use the WPI for `all commodities' for explaining the causes of inflation.

Thus, during the 1940s, economists such as Amiya Kumar Dasgupta, C. N. Vakil, V. K. R. V. Rao, and N. V. Sovani, warned the nation of the imminent danger of inflation due to expenditures on account of the Second World War and the post-War reconstruction activities.

In the 1950s, economists such as B. R. Shenoy and P. R. Brahmananda called for application of development strategies that would focus on growth sans inflation and pointed to the inflationary potential of large public outlays on large projects with long gestation periods financed in part by deficit financing.

In the 1960s, Gyan Chand, a socialist in orientation, wrote about the menace of inflation caused by such expenditure. In the 1970s, a number of economists petitioned to the Government about the need to control inflation that, according to them, was on account of large monetary expansion and the cost-push factor triggered initially by the 1973 oil crisis. Some economists had underscored the structural factors causing inflation. All these explanations of inflation till the end of the 1970s could be categorised in terms of demand-pull or cost-push or mark up or structural factors or a combination of these factors.

Interestingly, very few of these explanations, however, have pointed to the effect of price controls and rationing on the movements in the WPI. There was no question of market expectations about future inflation. It is no wonder that the observed long-term annual inflation rate thus was `repressed' at about 8 per cent till the end of the 1970s.

Since the end of the 1970s, there was no serious study on inflation in India. This is unfortunate because there has been a shift in the economic regime from the regulated one to market-orientation since about the mid-1980s and more particularly since 1992. The current complacency on the inflation issue could be partly due to the traditional mode of thinking about the measurement of inflation in terms of movement in the WPI. The users of the WPI also defend their preference on several other grounds such as the availability of data (a) on a weekly basis with a lag of hardly a fortnight, (b) on relative price movements in various commodities, or groups/subgroups of commodities and (c) based on larger number of commodity quotations than any other comparative indices such as the Consumer Price Index (CPI). Besides, they would argue that historical data on the WPI and the CPI for industrial workers show that they are positively correlated and so there would be no special advantage in using the CPI. Moreover, one could avoid making the choice as between the CPI constructed for three categories of consumers — industrial workers, urban non-manual employees and agricultural/rural labourers, on a monthly basis usually with a two-month lag. Furthermore, the use of the WPI avoids the problem of conducting sample surveys of consumer baskets such as those used for constructing the CPI.

It is this approach that has perhaps led to the total absence of any interest in improving our understanding of the inflationary processes through better measures than those used at present. The Government has not come out with any research study on inflation and its measurement. The Reserve Bank of India has at times come out with some individual studies on price movements, and on estimation of what could be the `core' inflation but they have been largely statistical in nature.

In order to know the impact of inflation, it is necessary to know the retail prices that enter the personal consumption expenditures. Here one needs to be careful to make a distinction between commodity inflation and services inflation. Insofar as commodity inflation is concerned, it would be necessary to have an idea of `core' inflation as an operative guide to policy. Core inflation is generally understood to mean the rate of increase in consumer prices on commodities other than food and energy whose prices are often beyond the control of the authorities as well as the effects of changes in indirect taxes. But it is important to remember that a mere trend study of such a measure would not be able to provide clues about the effects of taxes on expectations of future prices of taxed commodities, and their relationships with other commodities and wages. Trend studies would need to be supplemented by sophisticated studies that require modelling.

It is also important to make a thorough study of the services that most consumers seek. The excessive demand for educational services in English-medium schools and for private medical facilities as also for affordable private transportation facilities is a phenomenon that is widely seen throughout the country, at least in major towns and cities. There are many stories of persons with `marginal' means of livelihood getting into debt to educate their children in English-medium schools or to give the family members private medical care facilities.

There is no good official account of what constitutes services that consumers pay for on a regular basis. Nor is there readily available time series data on services prices. But once a determination is made about what constitutes the commodity inflation, and services inflation, it should be possible to arrive at the rates at which commodity and services inflation have proceeded. The experience in the US shows that for decades, prices of services had increased at a faster pace than the commodity prices. In the 1990s, the gap between the services inflation and commodity inflation widened in the US. This was partly due to the declining commodity inflation and the persistence of services inflation to be at relatively high levels.

Given the fact that the services sector's share in India's GDP is high and growing, there is no reason to believe that the phenomenon that has been observed in the US is not prevalent in our country at present. If the services inflation continues to rise and the commodity prices continue to be persistent at the present levels, the very notion of price stability would be called into question. It also needs to be seen whether there is any relationship between the services inflation and commodity inflation.

The approach underlined above is essential if one were to forecast inflation while formulating medium term macro-economic policies. Who would take the initiative in providing a meaningful view of what price stability means is a serious question that most policy thinkers and academics alike would perhaps like to duck. Should this be taken up by the publicised Knowledge Commission or by the existing agencies including the RBI?

(The author, a former Executive Director of the Reserve Bank of India, can be accessed on asurivasudevan@hotmail.com)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Pricey wheat

Some questions about inflation

Bean counters vs business sense

Trade crosses every border and touches every wallet in every nation

It is a very mixed blessing to be brought back from the dead

The challenge of turning a concept into reality

Reduce FDI to control trade deficit

Merton Miller's valuation theory

Privatise public utilities

Advani resignation