The Hindu Business Line : Problems with inflation indices

In India, the major index of inflation, or what is considered to be the headline inflation number, is the WPI (Wholesale Price Index). There is also the CPI (Consumer Price Index), but there are four different types of CPI indices, and that makes it fairly unwieldy. The four are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural labourers; and CPI Rural labour.

India is about the only major country that uses a wholesale index. Almost every other country uses the CPI as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for. The WPI doesn't really measure the exact price rise an end-consumer will experience because, as the same suggests, it's at the wholesale level. The weights of items in the CPI and WPI baskets are calculated based on detailed surveys and other calculations. The WPI is published on a weekly basis and the CPI, on a monthly basis.

Two questions

However, two questions must necessarily be asked. The first is how good these indices are and how good is the WPI in India. To answer the first, inflation indices are only as good as how well they are constructed and the different weights that are assigned to the items in the basket. The inflation rate can, in theory, be manipulated by adjusting the weights of certain commodities. Of course, it also sometimes happens in practice. For instance, recently, the Argentinean Government decided to take some "pesky" commodities out of the CPI index because they were contributing to too much inflation.

Another problem sometimes with an inflation index, and by definition the inflation rate, is that it can suffer from what is the base effect. Since inflation is typically calculated on a year-on-year basis, the inflation rate always depends on the base and that can sometimes either exaggerate or underplay the inflation rate. Of course, one deals with the cards given.

Now, how good is the WPI in India? The answer to that is, it is clearly a second best alternative. The WPI first deals with at the wholesale level. Haven't you sometimes felt that the price rise of common household items has grown more than what the inflation rate is? If we used the CPI, that issue would have been eliminated.

The other issue is that the WPI doesn't have any services in it. That clearly makes it a faulty index because we do spend a good amount of money on services, such as rent, etc. If one actually looks at the CPI basket in the US, rent has a fairly high weight. Also the fact that nearly every country uses CPI as a measure of inflation clearly indicates that CPI is a better index.

Reporting lag

But what's the issue in India? For starters, there are four different types of CPI and so that begs the question, which is the actual CPI one can use? However, the biggest problem why the CPI cannot be used in India is the fact that there is too much of a lag in reporting CPI numbers. In fact, as of the February 21, the latest CPI number reported is for December 2006. Because of this time lag, it makes it a practically useless number as far as monetary policy is concerned. However, this puts us in a bit of a quandary.

Monetary policy actions in any country are done based on the inflation rate, but in India it can be argued that monetary policy is being done looking at the wrong inflation rate. In fact, during December, the CPI was higher than the WPI. This should mean that the interest rate should be higher than what it is now. But because of the CPI lag, what rate do we look at? An old rate, or an inaccurate but relatively newer rate? You see the quandary.

(Send in your queries on economics to Whackonomics@gmail.com)

Sunil Rongala

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