Inflation

PGDM (PT) 2008 11 Session - 12

GDP Deflator is the only measure of inflation that takes into account the inflation in all the goods and services produced in the economy. Consumer Price Index (CPI) is a weighted sum of prices of a standard basket of goods and services consumed by a typical domestic consumer. Wholesale Price Index (WPI) is a price index of goods and services that are sold by producers. The WPI measures price changes from the perspective of the seller. If producers are receiving higher prices from their sales to wholesalers we can expect that retailers would have to charge higher prices soon that gets reflected in a higher CPI.

To account for differences in consumption patterns across households the CPI is compiled for industrial workers, urban non-manual employees, and agricultural labourers. Both the CPI and the WPI are measured using base year quantities as weights. Price indices that do this are called Laspeyre indices. A Laspeyre price index is calculated from a basket of fixed quantities of a given list of goods. We first calculate the total price of the basket of goods in the base period. Let the price index in the base period be 100. Then we calculate the total price of exactly the same basket of goods in a subsequent year j. Next we compute the ratio of the total price of the basket of goods in period j divided by the total price of the basket in the base period. The price index in year j then is this ratio multiplied by 100. It tells us the expenditure that must be incurred in year j as a fraction of the expenditure in the base year in order that we may obtain the same bundle of goods as in the base year.

Comparing WPI and CPI

Wholesale Price Index Consumer Price Index

Movement in wholesale prices CPI for Industrial Workers of 435 Commodities measures retail price of 260 goods/ services Index available on weekly Index constructed on a monthly basis with short time lag of 2 basis with lag of 1 month weeks Base year is 1993-94 Base year is 2001

Weighting diagram of WPI and CPI (Industrial Workers)

WPI
Primary Products Food Articles Minerals Fuel Group Coal Mining Electricity CPI 22.02 Food 15.40 Pan, Supari, Tobacco 0.49 & Intoxicants 14.23 Fuel & light 1.75 5.48 46.19 2.27 6.43

Manufactured Products 63.75 Housing Food Products 11.54 Clothing, Bedding & Textiles 9.80 footwear Chemicals 11.93 Miscellaneous Basic Metals 8.34 Machinery & machine tools 8.36

15.27 6.58 23.26

Differences between WPI and CPI

WPI Fuel group gets a much higher weight Services not included CPI Food gets maximum weightage

Miscellaneous group includes services such as transport, education, health, etc.

CPI (Industrial Workers)

Year GDP Deflator 10.00 9.08 7.55 WPI 12.60 7.99 4.61 CPI (IW) 10.08 10.21 9.27

1994-95 1995-96
1996-97

1997-98 1998-99
1999-00 2000-01

6.46
7.98 3.80

4.40
5.95 3.27

7.02
13.11 3.38

3.52
3.13 3.89

7.16
3.60 3.41

3.74
4.28 4.10

2001-02
2002-03 2003-04

3.80 4.37
4.45

5.46 6.42
4.43

3.73 4.00
4.23

2004-05
2005-06 2006-07

5.76

5.42

6.83

Inflation Rates
Year 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Average (1994/952006/07) Standard Deviation GDP Deflator 3.52 3.13 3.89 3.80 4.37 4.45 5.76 5.68 WPI 7.16 3.60 3.41 5.46 6.42 4.43 5.42 5.75 CPI (IW) 3.74 4.28 4.10 3.73 4.00 4.23 6.83 6.46

2.31

2.51

3.23

Trend Growth Rate

-6.75

-3.87

-7.74

Figure 1.6: Inflation Rates

14.00

12.00

10.00

8.00

6.00

4.00

2.00

0.00 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 Year 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

Source: Table 1.12

GDP deflator

WPI Inflation

CPI(IW ) Inflation

Price indices overstate true inflation due to 2 factors Price indices cannot account for price changes in newlyinvented goods as the indices are calculated on a bundle of fixed goods and undergo revision with a lag. For example, the prices of new computers tend to start high and come down rapidly as output expands and so the price index in the initial years would overstate inflation. Existing goods change in quality over time. For example, automobiles attributes over time have improved significantly - improved engine performance, innovations in luxury, comfort, and safety features. The price index overstates inflation in the price because it records a higher price which is the sum of the old, unimproved good plus the premium for higher improved quality.

Price indices overstate true inflation due to 2 factors Average real incomes are surely much higher today but there are also many more goods available. In 1980 people were using type writers instead of computers and they were lucky if they got to watch just one channel on a black & white television set.

There are a greater variety of ways of spending incomes today and by correcting for inflation we will not be able to capture that very important transformation in our lives.

Inflation Record

Inflation Tolerance
During the period 1951-52 to 2004-05, in 28 years inflation was below 6 per cent and in 40 years it was below 9 per cent. There are only four years in the entire period, when inflation was above 15 per cent. These years of high inflation basically reflect the impact of supply shocks, primarily due to setbacks in domestic agricultural production and external oil price hikes. The average inflation during 1951-2005 is estimated to be 6.5 per cent.

Inflation Record

Years of Deflation
1952-53, 1954-55, 1955-56 The deflation of 1952-53 is mainly attributed Higher agricultural production in that year, whereas high inflation of 1956-57 was mainly due to demand pressures, particularly investment demand in the light of the thrust on industrialisation in the second five-year plan. During the 1950s, two more years viz, 1954-55 (-6.71 per cent) and 1955-56 (-5.23 per cent) also witnessed negative price changes. Thus, notwithstanding low average inflation during 1950s, there was considerable volatility in the price movement.

Inflation Performance -1950s

In the pre-reform period, inflation had accelerated during the 1960s partly induced by the two wars in 1962 and 1965 and the crop failure of 1965-66 when agricultural production fell by more than 16 per cent. It became a matter of serious concern when it breached 20 per cent in the early 1970s led by a setback in agricultural production and an unprecedented hike in international oil prices. Prior to that, the 1950s witnessed average inflation of less than 2 per cent, but with considerable variation in yearly inflation. The percentage change in prices varied from a negative value of 12.8 per cent in 1952-53 to the highest inflation of 13.8 per cent in 1956-57

Inflation Performance -1960s

In the 1960s, average inflation increased to 6.2 per cent. Price changes were the lowest at a negative of 0.91 per cent in 1968-69 as a result of bumper agricultural production in the previous year. It was highest at 13.95 per cent in 1966-67, followed by inflation of 11.56 per cent in the following year. High inflation during these two years can largely be attributed to impact of the Pakistan war in 1965 and the famine experienced

Inflation Performance -1970s

The decade of the 1970s stands out as the most sensitive period in India in terms of inflationary uncertainty, witnessing very high inflation mainly driven by the supply shocks emanating from agricultural and oil prices. For the first time since independence, inflation overshot the level of 20 per cent in 1973-74 (20.2 per cent) and 1974-75 (25.2 per cent). A hike in oil prices and poor agricultural production led to reappearance of high inflation in1979-80 (17.1 per cent) and 1980-81 (18.2 per cent). The average inflation in the 1970s - 10.3 per cent

Inflation Performance -1980s

Inflation averaged 7.2 per cent per annum during the 1980s with a noteworthy reduction in inflation variability. Inflation varied between 4.4 per cent in 1985-86 and 10.1 per cent in 1990-91. The fiscal deficit of the centre widened from 3.8 per cent of GDP during the 1970s to 6.8 per cent during the 1980s. Close to one-third of this burden was borne by the RBI during the 1980s (close to a quarter during the 1970s).

Inflation in the Crisis Year

The year 1991-92 witnessed low economic growth of 1.3 per cent During the crisis year of 1991-92, inflation was 13.7 per cent. As a response to this crisis, an entire gamut of reforms covering external, industrial and financial sectors were introduced and the reform initiatives significantly contributed to a moderation of inflation. In terms of inflationary behaviour, the post-reform period can be distinguished into two sub-periods. The average inflation was around 9.8 per cent during the period 1992-96, which came down by half (4.9 per cent) during the period 1996-2005.

Threshold Inflation
The Chakarvarty committee had presumed the threshold inflation level at 4 per cent, which was supposed to be an "acceptable rise in prices purported to reflect changes in relative prices necessary to attract resources to growth sector". Later in the mid-1990s, under C Rangarajan, the then RBI governor, the apex bank focused on what is known as "acceptable level" of inflation rate at 6-7 per cent.

Threshold Inflation
the inflation rate (targeted absolute inflation) in Industrialised countries is less than 2 per cent, while most of the developing countries experience nearly double-digit or more inflation. Threshold level of inflation can be described as that inflexion point beyond which the output growth is not optimal. Empirical studies have shown that at inflation rates higher than threshold level, the output growth has retarded.

Threshold Inflation
inflation reduces real returns to savings and, via This mechanism, exacerbates an informational friction afflicting the financial system. This financial market friction might result credit rationing and thus limit the availability of investment capital (the level of investment) and reduce the efficiency of the allocation of savings to investment projects (the efficiency of investment), and Finally adversely affect the long-run economic growth.

Threshold Inflation
Barro (1995) suggested that a likely channel by which inflation decreases growth is through a reduction in the propensity to investment. Barro (1995)s further estimation shows that the impact effects from an increase in average inflation by 10 percentage points per year are a decrease in the ratio of investment to GDP by 0.4-0.6 percentage points and a reduction of the real per capita GDP by 0.2-0.3 percentage points per year.

Inflation to Economic growth transmission

Measures of Inflation Rate

In India, we have five different measures of the inflation rate The WPI (CSO) 1993-94 Base The Consumer Price Index for Agricultural Labourer (CPI-AL) (BASE 1986-87=100) Labour Bureau The Consumer Price Index for Rural Labourer (CPI-RL) (BASE 1986-87=100) Labour Bureau The Consumer Price Index for Industrial Workers (CPIIW) - Labour Bureau Base (2000-2001=100) The Consumer Price Index for Urban Non-Manual Workers (CPI-UNME) Base 1984-85=100.- CSO and The GDP Deflator.

Salient Features of price indices

Features of Different Measures

Of these, it is the WPI that is the most frequently used. WPI gives weekly inflation rates with a lag of two weeks. The CPI-IW is important because it is used to calculate dearness allowance (DA) for organized sector employees. CPI-IW is available monthly with a lag of two months but, unlike the WPI which covers the entire county, it is constructed for 40 odd cities and towns.

Features of Different Measures

The four broad measures of CPIs available at the national level to capture prices of a defined basket of goods and services consumed by a particular segment of the population are: (CPI-AL) (defined as households which derive half their income through agricultural labour); CPI-RL (households which derive half their income through rural labour); CPI-IW (working class families, essentially in urban areas) and CPI-UNME (urban middle class families).

Features of Different Measures

There are two key sources of difference in the four CPIs. The weight of cereals is about 10 per cent in the CPI basket for urban non-manual employees and about 20 per cent for industrial workers, while it is around 40 per cent for the agricultural/rural labourers. Housing is not considered in the CPI for agricultural/rural labourers, while it has a weight of as high as 16.4 per cent in the CPI for urban non-manual employees and 8.7 per cent in the CPI for industrial workers.

Harmonised Index of Consumer Prices (HICP)

Although various measures of CPI do move together in the long run, significant variations have been observed in the short-run (Chart). This renders the interpretation of inflationary pressures difficult which, in turn, complicates the process of monetary policy formulation. The analytical value of information provided by different CPIs, however, can be enhanced by combining them into a Harmonised Index of Consumer Prices (HICP) which assesses consumer price inflation on an economy-wide scale.

Whole sale Price Index

To reflect the structural changes in the economy that have taken place Over a decade, a large number of commodities have been added and a few with diminished importance have been dropped. In the revised series, Primary Articles contribute 98 items, Fuel, Power, Light and Lubricants 19 items, and Manufactured Products provide 318 items. The number of price quotations in the revised series is spread out to as many as 1918 quotations.

Revising the 1993-94 WPI Series

In all, there are 136 new items in the revised series. Out of that, Primary Articles account for 13, Fuel Group contributes 1 and Manufactured Products have 122 new commodities.

Revising the 1993-94 WPI Series

Revising the 1993-94 WPI Series

The Working Group has also decided to recommend initiating the process of compilation of Producer Price Index (PPI) simultaneously, with the objective of ultimately switching over from WPI to PPI. PPI measures price changes from producers perspective as against the consumer price index which measures these from consumers perspective. Many of the countries have switched over to PPI from WPI.

Revising the 1993-94 WPI Series

In PPI, only basic prices are used for compilation, while taxes, trade margins and transport costs are excluded. PPIs, apart from their use as measure of inflation, are used as deflators in the compilation of GDP. PPI is considered to be a better measure of inflation as price changes at primary and intermediate stages can be tracked before it gets built into the finished goods stage. The Working Group has decided to shift the base from 1993-94 to 2000-01 for the new series.

Inflation Record

Wedge between CPI inflation and WPI inflation

Could be attributed to (i) the divergence in the composition of the two commodity baskets; (ii) supply management; (iii) administered pricing of certain commodities in the WPI basket; and (iv) non-inclusion of services and housing in the WPI basket. The divergence between the CPI and WPI in India during 2003-04 was mainly due to the sharp rise in iron and steel and fuel prices which were key movers of WPI inflation, but had lower weightage in the CPI basket. Also, food prices in 2003-04 did not increase at the retail level as much as at the wholesale level, reflecting prudent supply management.

Features of Different Measures

The GDP Deflator is the most comprehensive measure of inflation since it covers services and non tradable commodities as well but GDP Deflator is a statistically derived measure (ratio of GDP at current prices to GDP at constant prices) and GDP Deflator not used in popular discourse as it is available only annually.

Features of Different Measures

The WPI which uses 1993-94 as the base year and covers 435 items is called the "headline" rate of inflation since it is the rate that captures news every Monday. There is a point-to-point measure, which calibrates the rate of increase in a particular week or day of a particular year over the same week or day the previous year. The other is the 52 week average. Both are used but the weekly point-to-point is what dominates headlines.

CPI-IW
The consumption groups commonly adopted for working class consumer price index numbers are as follows: IA - Food IB - Pan, Supari, Tobacco & Intoxicants II - Fuel and Light III - Housing IV - Clothing, Bedding and Footwear V - Miscellaneous. The previous series of Consumer Price Index Numbers for industrial workers at Base 1982=100) has been changed to 2001=100.

CPI-IW
Food Group:
(a) (b) (c) (d) (e) (f) (g) (h) Cereals & Cereal Products Pulses and Pulse Products Oils and Fats Meat, Fish and Eggs Milk and Milk Products Condiments & Spices Vegetables & Fruits Other Food.

CPI-IW
Miscellaneous Group
(a) (b) (c) (d) (e) Medical Care Education, Recreation & Amusement : Transport & Communication Personal Care & Effects Others

Construction of All India Index

The All India Index is the weighted average of the 78 centre level indices. The centre weights are being determined as the ratio of product of average consumption expenditure per family as per the main survey and the number of Working Class Families represented by a centre in a State to sum of such products over all the centres.

CPI-UNME
CPI-UNME (Base 1984-85 = 100) has limited use and is basically used for determining dearness allowances of employees of some foreign companies working in India in service sectors such as airlines, communications, banking, insurance and other financial services. It is also used under the Income Tax Act to determine capital gains and by the CSO for deflating selected service sectors contribution to GDP at factor cost at current prices to arrive at the corresponding figure at constant prices.

CPI-UNME
For shifting the present base of CPIUNME, presently, on the advice of its governing council, the National Sample Survey Organisation (NSSO) is conducting a Family Living Survey (FLS) to obtain the profile of the present consumption pattern of urban non manual employees. The CSO is also examining the possibility of constructing a consumer price index for the urban employees.

CPI-AL
CPI-AL is basically used for revising minimum wages for agricultural labourers in different States. The present base year of CPIAL is 1986-87. As the consumption pattern of agricultural labourers has changed since 1986-87, the Labour Bureau proposes to revise the base of the existing series of CPIALby using the consumer expenditure datacollected by the NSSO during its 61st NSS(200405) round.

Construction of All India Index

In order to pre-empt over weighting to big cities in respect of their contribution to All India Index, each centre is assumed to represent an equal share of the number of working class families within the State. In case the actual working class population (as per the main survey) for a particular centre exceeds the proportionate share accruing to the centre, the actual population of the centre is taken to determine its share and the remainder of the working class population in the State as a whole is equally distributed amongst remaining centres in the State.

Miscellaneous Group:
(a) (b) (c) (d) (e) Medical Care Education, Recreation & Amusement Transport & Communication Personal Care & Effects Others

Features of Inflation
A current inflation rate has both a permanent and transient segment. Transient components arise from sudden shocks-like when the prices of onions or crude oil shoot up or when the prices of edible oils come crashing down. As Reddy says, core inflation has only a permanent component. Core inflation is the future-underlying rate of inflation anticipated by economic agents that does not change with changes in output-either up or down.

Core Inflation
Core 1: WPI minus primary food articles and administered price commodities; Core 2: WPI excluding primary food articles, primary non food articles (like cotton, sugarcane and oilseeds) and administered price commodities: Core 3: WPI excluding primary food articles, manufactured food products and administered price commodities: Core 4: WPI excluding primary food and non food articles, administered price commodities and all other seasonal items

Core Inflation
After detailed statistical analysis, Samanta concludes that Core 2 is the least volatile and the most superior measure. Presumably, RBI Governor had this in mind, although it appears from the figures he quoted that he may have used Core 5-WPI excluding administered prices.

Core Inflation
The concept of "core" inflation has been officially used in a policy sense. The RBI did draw attention to the concept in its 199697 Annual Report. Later, an econometric study on the subject by an RBI analyst G P Samanta appeared in the summer 1999 issue of RBI Occasional Papers. Subsequently, the RBI's Deputy Governor Venugopal Reddy discussed it in a lecture he gave in Hyderabad in August 1999.

Core Inflation
Core inflation could be core to the central bank's monetary policy but it certainly is not core as far as the government or consumers are concerned. If you are going to exclude increases in primary food articles with a weight of 15.4 per cent in the WPI, primary non food articles whose weight is 6.6 per cent and administered price items whose weight is 16.4 per cent, then you are really not reflecting real world concerns.

SWFs
The Government Pension Fund - Norway is a fund where the surplus wealth produced by Norwegian petroleum income is put. The fund changed name in January 2006 from its previous name The Petroleum Fund of Norway. The fund is commonly referred to as The Petroleum Fund. As of the valuation in June 2007, it is the largest pension fund in Europe and the second largest in the world with a value of NOK 1.939 trillion. The Kuwait Investment Authority (KIA) is Kuwait's government investment arm, specializing in local and foreign investment. It was founded to manage the funds of the Kuwaiti Government in light of financial surpluses after the discovery of oil.

THANK YOU