The Hindu Business Line : Plus or minus?

Here is the oldest chestnut of all: If the price of bread rises but the cost of petrol falls, are you better or worse off? What does this mean for your monthly expenses?

If you ask the Government it will say you are better off when the rate of inflation comes down. But inflation in what? Of wholesale prices or retail prices?

In 1988, at the routine post-budget press conference, I asked the officials if it was such a great idea to persist with the wholesale price index, which contained esoteric items like jute, hemp and mesta (ever heard of the last two?) as an indicator of what was happening to prices in the economy. I was told that India would “very soon” have a retail price index.

But even granting that time moves slowly in this ancient land of ours, surely 20 years was long enough for that index to have been constructed. But no such luck. We are still asking if we are better off when the price of bread rises and the price of diesel falls.

Inflation refers to the increase in prices of goods and services over time. Not desirable, one would think but contrary to perception, it is desirable. This is because even though inflation reduces effective wealth for a consumer, it increases income and profits for a producer. And because producers are themselves consumers, the feedback process continues.

The opposite also holds true. If prices fall too much, the income and profits of the producers get reduced and that translates into lower consumption. This is what we are seeing globally now. So what policymakers are generally concerned about is too much (or too little) inflation. The problem, of course, is no one knows what the ‘right’ level of inflation is.

Conceptually, inflation defines the distinction between the nominal value of your money and its real value. Suppose you have Rs 1 lakh in the bank which is not earning any interest, and inflation is at 5 per cent every year for five years. Five years later, you will still have Rs 1 lakh in the bank — its nominal value will not have changed.

But were you to withdraw that amount and go shopping, you would find that you are able to buy a lot less than you would have been able to five years ago. Sustained inflation over five years has reduced the real value of your money. That is why people demand interest. But, before you curse inflation morning, noon and night, remember one thing though: without inflation you would not get your annual increments.

So what does all this mean? Net-net, it means that the effects of inflation are different, depending on whether you are a producer, a seller, or a consumer. Not surprisingly, therefore, there are three possible perspectives to measuring inflation.

These are captured by the producer price index (PPI), the wholesale price index (WPI), and the consumer price index (CPI). Before we discuss their relative merits, let’s see how they are calculated to begin with.

The process starts with identifying goods and services that are deemed essential from your perspective. For a producer, this would include raw materials and the cost of inputs to production. On the other hand, for a consumer, this would include the cost of food, fuel, living expenses, and so on.

Once the lists are determined, they are assigned a statistical device called weights to denote the importance of the item in question. Basically, they see what fraction of your income you spend on that item or class of items such as food, electricity, clothing and so on.

Once they have the lists of goods and services, their prices, and the weights assigned to them, they add it all up and the weighted sum of prices gives them the value that they we are looking for.

To see how this works, pick any year as a benchmark and then compare the weighted sum to the value in that year. You will be able to see whether prices have increased or decreased since then. You can also tell by how much.

Thus, suppose you want to compare prices in 2000 and now. Suppose next that the weighted sum of consumer prices gives you a value of 100 in 2000 and 130 in 2008. This means prices now have risen 30 per cent over 2000.

Easy, right? Well, don’t let the economists and statisticians fool you because different measures of inflation can move in different directions. And this is because the direction in which they move depends on what they are comprised of.

So we come back to the original question about bread and petrol prices. In the past few months, fuel prices have come down substantially. This will have had different effects on India’s WPI and CPI, depending on the weights (how much you spend on them) attached to them. Any change in food prices, too, will have disproportionate effects on the two measures.

It is often said that one should be careful about what one wishes for. For months we have wished for inflation to reduce, and now it has. But along with it has come a gloomy economic outlook for the months ahead for producers — who if they don’t sack you outright, will certainly not give you the increment you think you need or deserve.

Related Stories:
Problems with inflation indices
What is inflation and what causes it?
Inflation insights
Whom does inflation hurt?
Producer price index to replace WPI next fiscal

More Stories on : Economy | T.C.A. Srinivasa-Raghavan

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