The complex interplay of price and growth variables has made the task of monetary policy rather difficult. Let’s take the Wholesale Price Index (WPI), which has earlier been the inflation anchor for monetary policy. It has a bigger commodity basket and derives its weights from national accounts based on traded value of commodities. WPI is an exclusive commodity price index, and it excludes services.
Since the weights in WPI are based on traded value, it assigns much higher weights to manufactured products relative to their share in GDP as the ratio of value added to output in manufacturing is nearly four times the ratio of value added to output in agriculture. It captures prices at first point of sale.
Little correlation
As against this, CPI (Consumer Price Index) draws commodity weights from NSSO consumption survey. WPI and CPI inflation hardly have any correlation, though WPI food has a reasonable correlation with CPI food, largely because the commodity composition is nearly aligned. Low correlation between overall WPI and CPI inflation is largely because half the weights in WPI comprising basic goods, capital goods, and intermediate hardly figure in CPI.
From the perspective of producers and their investment decisions, WPI inflation is the real anchor and hence equally important from policy perspective. Further, since it represents inflation for producers and serves as the first point of changes in prices, it captures impact of international commodity prices. High correlation between WPI and CPI for food and WPI being the sole indicator of price movements of basic, intermediate, and capital goods, it is helpful in deciding structural intervention in trade and fiscal policies.
Inflation trend
WPI inflation has been more volatile than CPI. Until 2020-21, WPI inflation was lower than CPI across all segments other than food. Lower producer inflation relative to the price rise for consumers indicates generally increased profitability for producers and increased margins for final retailers. However, available data does not indicate existence of significant pricing power except during the lockdown period for listed companies and those engaged in sale of food items.
This trend is supported by data on overall profit-after-tax to sales, which has moderated for non-government public limited companies and industries engaged in machinery and equipment between 2015-16 to 2018-19. It is possible that moderate and negative inflation in the basic goods in most part of the last seven years (except during 2017-19) would have contributed to this inflation scenario.
Another notable factor is that inflation in capital goods has remained moderate and relatively stable during these years even though there has been volatility in inflation of basic goods and intermediates. The capital goods industry has maintained prices adjusting their margins.
Pandemic effect
The scenario sees changes after the pandemic. The ratio of profit after sales of listed companies during the pandemic more than doubled from 3 per cent to 7.2 per cent despite decline in sales. Incidentally, the margins across pulses and edible oil showed sharp increase while cereals and milk showed the impact of supply chain disturbances.
It was also noted that the correlation of inflation of capital goods with overall inflation was low, being even lower than basic goods and intermediates. Low inflation for capital goods and intermediates would be most probably due to sluggish demand, change in commodity composition within capital goods, shortening of life of a product to changes in design or technology and decline in pricing power of the producers. Basic goods follow generally international prices, and their domestic prices vary with fiscal policy.
The structure of inflation based on both WPI and CPI suggest that monetary policy alone is not sufficient to maintain price stability. While monetary policy should act irrespective of what triggers inflation, supply shocks should be handled through fiscal route.
It is seen that sub-groups of basic goods, capital goods, intermediate, consumer durables and consumer non-food non-durables have moved in a narrow range in the past seven years. The indicators for basic goods have witnessed greater volatility, while for others, they remain steady. Long-term trend suggests management of domestic supply in spite of global commodity price movements is equally important in managing inflation in India.
Since the onset of the pandemic, the RBI has been addressing systemic liquidity, concerns of specific sectors and has been keeping interest rates low. Along with active fiscal support from the government, this would make the economy reach GDP levels of March 2020 by March 2022.
What is needed to take growth to a higher orbit is pick up in investment. The trend in this is encouraging as GFCF (gross fixed capital formation)at current price has reached 31.2 per cent in Q4 of 2020-21. This is the highest so far in the past 27 quarters. The improvement in GFCF together with rebuilding of inventory levels gives some comfort that excess liquidity has not created bubbles.
A bit of negative information is that consumer confidence is still struggling to improve. Another uncomfortable news is that urban unemployment rates are at 9.3 per cent according to Periodic Labour Force Survey Report of Q4 of 2020-21.
Way forward
All these pose dilemmas for monetary policy. There may be a justifiable view that the RBI needs to end the accommodative monetary stance and revise policy rates upward because of sticky core inflation and improved performance based on high frequency indicators. On the other hand, personal consumption expenditure of Q2 of 2021-22 remains less than Q2 of 2018-19 and growth is yet to become more broad based.
In Q2 of 2021-22, buoyancy in growth was on account of Public Administration, Defence and Other Services. We have not been able to achieve significant improvement in employment levels. As we have argued earlier, stickiness of core inflation is more due to structural factors which need to be addressed through other means. From all the above, there exists a reason for not altering the current stance of monetary policy immediately.
Gopalan is a former Finance Secretary, and Singhi is a former Senior Economic Adviser, Ministry of Finance