Price of confusion

Suddenly, the rift between the Reserve Bank of India and the finance ministry on managing growth and prices has taken an egregious turn. Chief Economic Advisor Arvind Subramanian, referring to the wholesale price index trend (WPI) since November 2014 as well as the GDP deflator, has said that we have a problem of deflation — not inflation — on our hands. This comes barely a week after the RBI’s annual report saying that “inflation projections for January 2016 are still at the upper limit of RBI’s inflation objective”. Days after the release of the report, Governor Raghuram Rajan recanted by hinting that a rate cut was on the cards. Indeed, it should be, when growth, and not prices, is the threat. The report itself points out that the minus 4.1 per cent reading of the WPI for July included a fall of 1.4 per cent fall year-on-year in manufactured products, “indicating the extent of slack in the economy as well as falling cost pressures”. The RBI has, in a way, conceded that by using just the consumer price index (CPI) as an inflation indicator it may have missed the lurking threat of deflation. It has had little to say on the divergence between the WPI and CPI (a staggering 10 percentage points for July!), an issue over which Rajan’s predecessor D Subbarao expressed bewilderment two years ago when the divergence then was about five percentage points. Intermediation costs cannot explain this order of difference. Finally, the confusion led to the move to track CPI as being truer to the aam aadmi ’s inflation experience. We now know that in doing so the WPI and the GDP deflator should not be disregarded. Prices according to the deflator, which tracks the difference between output at current and constant prices, are growing at just 1.7 per cent. The deflator is considered a reliable indicator, but is available only on a quarterly basis.

Both, the CPI and WPI are declining due to low commodity prices, but the growing gap since December 2014 also indicates a lack of demand for intermediate and final goods, in other words, deflation. The RBI should fine-tune its ‘inflation-targeting’ methods by tracking the CPI, WPI and GDP deflator and arriving at upper and lower limits for all. A wrong estimate of both the actual and targeted inflation rate can lead to a wrong estimate of the ideal repo rate as well (through the ‘Taylor rule’, a formula that central bankers tend to use). Differences between indices must be taken into consideration. A falling WPI is evidence enough of a weak investment climate.

While the Centre is doing its bit by spending on infrastructure, a rate cut would help industry overcome an adverse debt and inventory situation. If the Fed desists from raising rates this month, as it well might in view of hardening US yields in the wake of China and other countries dumping US Treasury Bills, it will give room for the RBI to cut rates 10 days later. The rupee is unlikely to require interest rate support — unless, of course, there is another financial earthquake.

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