Pooja Mirchandani: The 'true' rate of inflation

The WPI, suitably adjusted for oil, reasonably depicts the inflationary situation in the economy.

There are three measures of inflation in India: the wholesale price index (WPI), the consumer price index (CPI), and the gross domestic product (GDP) deflator. The WPI is the widely used measure of inflation because of its frequency and timeliness "" it is available on a weekly basis with a lag of two weeks. The WPI is available for all commodities, major groups, sub-groups and even individual commodities. However, the index does not cover non-commodity producing sectors such as services, which have a large share of economic activity.

The CPI, which is meant to reflect the cost of living conditions, is computed using the retail prices of goods and services on which a homogeneous group of consumers spend a major part of their income. The CPI is available on a monthly basis with around two months lag. The difference between the WPI and CPI measures of inflation arises from a wide variation in the composition and coverage of items and also the weighting pattern. The WPI gives more weight to manufacturing products, and while services do not come under the ambit of WPI, the coverage of non-agricultural products is much better in the WPI as against the CPI. The CPI, on the other hand, gives higher weight to food articles and includes services, such as education, medical care and recreation.

The third indicator of the price change in the economy is the GDP deflator, which converts GDP at current prices to that at constant prices. Since it is derived from the national accounts data of the economy, the deflator encompasses all goods and services produced in the economy. Also, unlike the WPI and CPI, for which the basket of goods remains constant in between base revisions, the GDP deflator basket adjusts to the production pattern in the economy, allowing the index to instantaneously capture structural changes. The deflator, however, is available at the quarterly frequency, with a one-quarter lag and it is revised after a year or more.

Clearly, each measure has its strengths and weaknesses. From a policy perspective, timeliness is obviously the most important attribute and the WPI scores on that count. But, is it reflective of the "true" rate of inflation in the economy?

The above graphic charts the quarterly year-on-year inflation rate as captured by these three price indices since 1997-98. Over the period, inflation based on the CPI and GDP deflator tends to follow each other more closely than the WPI. The correlation coefficient between inflation rate as indicated by the CPI and GDP deflator is 0.87, whereas WPI inflation shares correlation coefficients of 0.27 and 0.19 with inflation based on the GDP deflator and CPI respectively. However, though there has been some divergence between the movements of the indices, there has not been any systemic bias.

However, more relevant to the policy context, since 1999-00, we have not seen such a large variation between the three indices. Inflation based on the GDP deflator has been the most stable, largely falling between the other two indicators of inflation. The mean inflation during 1999-00 to 2005-06 was 3.7 per cent as indicated by the GDP deflator and the volatility, measured by standard deviation was 0.8. Mean CPI inflation during the same period was 4.0 per cent with standard deviation of 1.1, whereas mean WPI inflation was higher at 4.8 per cent and the standard deviation was 1.7; the coefficient of variation (ration of standard deviation to average), which indicates relative volatility, was, therefore, the highest for the WPI.

WPI-based inflation saw two peaks since 1999-00, first during 2000-01 and second, during 2004-05. These were the two periods when it overshot the inflation shown by the other two indicators. But, both these periods correspond to rising crude oil prices. The fuel group was the major contributor to inflation during these episodes. Fuel has a higher weight in WPI compared to CPI "" 14.2 per cent versus 6.28 per cent. Volatile fuel prices have been the primary source of volatility in the WPI.

Three observations can be made with reference to the "true" rate of inflation in the economy. Over the last few years, there isn't much divergence between the three measures, suggesting that the true rate is somewhere in the vicinity of all three. Two, the WPI, which, because of its timeliness, is the most useful for policy consideration, shows a higher rate of inflation on the average than the other two indices. This implies some risk of over-reaction by policy makers. Three, that risk, however, is mitigated by the fact that the difference, as well as the volatility in the index, is largely due to the movement of oil prices, which have the highest weight in the WPI. Removing these, as is usually done to measure "core" inflation, increases the proximity of the three indices. At least, in the current scenario, it appears that the WPI, suitably adjusted for oil, reasonably depicts the inflationary situation in the economy.

The writer is Economist, CRISIL.