The limits of CPI: It doesn't capture the true cost of living

Consumer price index boasts of a rigorous and robust design, but there are quite a few issues with it

As the cost of living shoots through the roof, the consumer price index (CPI) has become one of the most watched indices. The Monetary Policy Committee (MPC) is trying to anticipate the future movement of the index at each meeting to decide on the policy rates. It is acting cautiously — it raised the repo rate by 50 basis points a few days ago to avoid shocking the stock and bond markets, though the CPI has stubbornly remained outside its target zone of 4 per cent +/- 2 per cent on either side.

The Union finance minister has had to defend the government’s economic performance regularly in the past few months. Meanwhile, the middle income segments of the population voice doubts about whether the CPI is measuring the cost of living accurately —many feel that their household expenditures have risen far more than the headline CPI numbers reported by the government. Many grumble on social media that the statistics department is fudging numbers.

It is easy to get fixated on the monthly and annual movement of the CPI without understanding its strengths as well as the shortcomings. The Indian CPI is a handy index that seeks to track how retail prices of a host of goods are going up. It was designed to capture the price movement of a typical Indian consumption basket that would be representative of the purchase habits of a large portion of the population based on a comprehensive consumption expenditure survey carried out by the statistics department. It, therefore, can boast of a rigorous and robust design. But there are quite a few issues with it, and those issues have become more serious with time. Let us take a look at a few of them:

1. The consumption basket is outdated. It was last revised in 2015 using the consumption expenditure survey of 2011-12. The weightage assigned to food in the CPI consumption basket is just under half. (There are some variations in the baskets for rural and urban areas). The rest is made up of a range of other goods and a few odd services. It contains many outdated items that are no longer relevant in 2022. And it has been pointed out by many eminent economists — from former chief statistician of India Pronab Sen to Ashima Goyal, who is currently a member of the MPC — that the CPI basket needs to be overhauled drastically. The problem is that the government refused to accept the Consumer Expenditure Survey (CES) of 2017-18  citing data quality issues. The basket is likely to undergo a major change only in 2024-25 — assuming the next round of CES comes in before that. Until that happens, the inflation numbers are unlikely to reflect the actual household spending. So, if you feel that the official CPI data is not reflecting the speed at which your household expenditure is going up, you are probably right.

2. An outdated index leads to policy experts misreading all sorts of economic data. Take, for example, the rising goods and services tax collections. Bureaucrats often boast how it shows robust economic growth and higher consumption of goods and services. But GST collections reflect current prices and it is easy to get carried away with the headline numbers if you do not account for inflation making up a good portion of that rise. Economic commentators often make the mistake of thinking that GST collections are rising much faster than inflation as measured by CPI. The CPI basket, however, doesn’t cover a lot of products and services and therefore doesn’t reflect the true extent of the price rise either. Ditto for exports.

3. Monetary policy that is overdependent on CPI numbers can go awry. This has been pointed out by many prominent economists, though there is little consensus on what should replace it. Some economists have said that the RBI should focus on core inflation, which is CPI without food and other volatile elements. Others think that both CPI and wholesale price index (WPI) should be used together. Till 2015-16, the RBI used the WPI for setting policy rates. It was criticised widely because between 2008 and 2013, there was a huge divergence between the WPI and CPI, with the CPI in double digits while the WPI was much lower. After much debate and the Urjit Patel Committee report of 2014, the RBI decided to adopt the CPI as the primary index for its flexible inflation targeting framework. But now the situation has reversed — the WPI has been persistently in double digits, while the CPI is half that.

4. Finally, the ability of the monetary policy to tame CPI that is not demand-led but supply-starved is suspect. The basic logic that the RBI and other central banks follow is that higher interest rates and tighter liquidity can help reduce appetite for excessive consumption with a lag. The problem is that it is limited in effectiveness against both food inflation as well as price rise caused by supply-side disruptions such as the Covid pandemic and the Russia-Ukraine war. For example, if the price of fuel has shot up because of disrupted global supply chains, the government’s fiscal policies like import duty cuts may help far more than any monetary policy measures.

 The CPI is an important tool — but understanding its limitations, especially in the Indian context, is extremely important while devising the correct policy response.

The writer is former editor of Business Today and Businessworld, and founder of Prosaic View, an editorial consultancy