Accurate measurement of demand-side pressures holds the key to effective inflation control.

Imagine the situation if the Euro Zone crisis worsens in the coming months — what if, in an extreme scenario, Greece is unable to agree to the stringent conditions of the bailout package and is forced out of the Euro Zone? What if, then, global crude and commodity prices tumble? How would this reflect in our inflation data?

The Wholesale Price Index (WPI) consists of prices of primary articles, fuels and manufacturing articles, including metals. If international crude oil and metal prices tumble again, fuel and manufacturing inflation too will fall. Overall, WPI inflation could also moderate sharply, if the Euro Zone crisis blows up. The sequence of events could be similar to what happened in 2009-10, post the Lehman collapse.

Generally, a decline in inflation tends to suggest a drop in the demand pressure, especially when domestic growth is slowing. But, if inflation falls sharply, triggered by a fall in the global oil and commodity prices, can we draw meaningful conclusions about the demand strength in the economy? The answer is no.

A reliable measurement of economy's demand-side pressures should eliminate the effects of transitory supply shocks. Such a demand-side inflation measure arrived at by excluding certain components of the price index is called core inflation.

Since March 2010, the Reserve Bank of India (RBI) has been using non-food manufacturing inflation (NFMI) as a core inflation measure for India. NFMI is computed by excluding the prices of primary articles, fuel group and processed food from the WPI. We believe that core inflation measurement for India can be improved by making two changes to the current measure.

Base metal prices

Firstly, core inflation should exclude base metal prices (directly influenced by international prices).

Given that these prices have a significant weight of nearly 9 per cent in NFMI, any sharp movements in metal prices can heavily influence it. For instance, in 2009-10, international base metal prices witnessed a steep fall. During the same period, domestic base metal prices also contracted by 8 per cent compared to nearly 12 per cent growth in the previous year.

This contributed heavily to the sharp fall in NFMI in 2009-10. Secondly, the current measure of core inflation excludes processed food prices, which, unlike raw food prices, denote the demand strength in the economy.

If the processed food prices continue to show a robust increase, then it suggests that private consumption demand remains robust fuelling the price rise. Therefore, excluding prices of processed food may erroneously show a moderation in demand.

The CRISIL core inflation indicator (CCII), released in April 2012, therefore, includes processed food prices, but excludes base metal prices from the RBI's core inflation measure.

In doing so, the CCII, we believe, measures demand-side pressures in the economy more accurately. During periods of adverse shocks to the global economy, CCII is less influenced by temporary shocks. For instance, in 2009-10, CCII was still high at 4.2 per cent and had in fact reached 6.0 per cent by December 2009.

Fall in commodity prices

Now, let us go back to where we started — if the Euro Zone crisis deepens, leading to further slippage in global growth, commodity prices could nosedive. In this situation, the existing measure of core inflation, NFMI could drop sharply again — mirroring the trends in 2009-10. While domestic demand pressures are also on a decline currently, the drastic fall in NFMI could exaggerate the extent of true decline in domestic demand. CCII could however fall to a lesser extent and might begin to pick up earlier if private consumption recovers on the back of some fiscal stimulus.

Alternatively, if international metal prices remain robust despite the Euro Zone troubles, but domestic demand wanes rapidly, NFMI could remain relatively high and may not accurately reflect a severe decline in domestic demand. In contrast, CCII would fall further. In such scenarios, accurate measurement of demand-side pressures would hold the key to effective inflation control.

Once sufficient time series becomes available for the newly introduced consumer price index, the core inflation measure based on it would replace those based on WPI. If, for now, we have to rely on WPI to arrive as an indicator of core inflation, CCII appears to stand out as a better choice for determining the extent of demand pressures in the economy.

(This article was published on June 16, 2012)
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