An inflation-targeting central bank like ours should have a credible inflation measure, and like every other key fiscal or monetary parameter, this too needs a check.
Published Date – 12:54 AM, Sun – 18 December 22
By Anitha Rangan
Hyderabad: The policy narrative in the last one year has undergone a dramatic shift: what had been thought at first as transitory inflation has now become persistent. Policymakers have shifted their priorities — from supporting growth to fighting inflation, from liquidity injections to balance sheet reduction. They have embarked on a course correction: from whatever it takes to whatever I can break. Resultantly, financial markets have reacted sharply to this regime shift, affecting returns, correlations and dispersions across and within assets.
While there is some indication of inflation peaking, the fight against inflation is far from over. Though headline numbers have peaked, it is not broad-based yet. In some parts of the world, it is food, in some parts, it is base effects but core is still persistent in most parts of the world. Core inflation is inflation-related to inflation excluding food and energy. Headline inflation is inflation-related to all the economy’s commodities, goods, and services.
Global Dynamics
Inflation has doubled or more than that in 37 of 44 advanced economies over the past two years, according to the Pew Research Center. Turkey had, by far, the highest inflation rate in the first quarter of 2022, at 54.8%. The country where inflation has grown the fastest is Israel, with a 25-fold increase. But there have been some minor exceptions.
Let us examine the root cause of this global inflation spiral. It is common knowledge that the post-pandemic demand upswing, exacerbated by the impact of the war in an environment of abundant low-cost liquidity, has been primarily behind this extraordinary spell of inflation. Large global excess savings and exceptionally strong global excess demand for many internationally traded goods and commodities have contributed to raising the pricing power of firms across advanced economies. This has fed into underlying price pressures even in countries where domestic slack remains present.
The extent and persistence of future underlying price pressures will depend on two things: the degree to which firms will be able to continue passing higher input costs on to consumers, and whether higher profits will translate into higher wages.
The fact that inflation is, to a considerable extent, driven by global factors, however, does not mean that monetary policy can or should remain on the sidelines. On the contrary, persistent global shocks imply that the firm anchoring of inflation expectations has become more important than ever. Therefore, most of the central banks started acting in earnest with super-sized policy rate hikes and tightening their balance sheets. While the super-sized hikes are now shifting towards relatively lesser-sized hikes, nevertheless, terminal rates are expected to be farther, higher and perhaps may last longer.
India’s retail inflation does not include certain components like services from restaurants (food away from home), ownership of housing (under housing services), financial services including insurance
Headline Vs Core
The Reserve Bank of India’s mandate talks about headline and not core inflation. On many occasions, inflation excluding food has been much higher than headline inflation. However, we have observed that core inflation can be sticky and less volatile. Similar to the Fed, the RBI could perhaps pay attention to both headline and core (like the personal consumption expenditures [PCE] and Core PCE used by the Fed).
Several components of core inflation like clothing, health, household goods and services, personal care items have seen a persistent increase in the last 24 months. Food inflation can be volatile, led by monsoon vagaries and, therefore, has a tendency to be “looked through” while components of core inflation are more sticky. We are already seeing this — while headline CPI (consumer price index) is coming down, led by the seasonal impact of vegetables, core is not.
However, with CPI as the nominal anchor for RBI, adequacy in the measurement of retail inflation is critical. Perhaps it’s time to revisit the nominal anchor itself as to whether it should be only the headline or weightage should be given to core inflation as well. In any case, if we take comfort from domestic inflation being less sinister than the world, it has to be comparable. Looking at the global retail index composition, it definitely feels that in India, food is eating more than its share!
Determinants
The current CPI construct has been followed from 2015 onwards with the base year of 2012 and measures the change in prices of goods and services consumed by the average Indian consumer.
The weightages and pattern are based on the Consumer Expenditure Survey (CES) of 2011-12. However, is it a good reflection of the average consumption basket and how does it compare with the rest of the world? But before we look at the construct, let us examine some of the underlying trends in inflation.
Looking at the key headline components in comparison with the developed world, India’s very high proportion of food leaves less room for other services like housing, transport and communication, recreation and other household goods and services. Furthermore, India’s retail inflation does not include certain components like services from restaurants (food away from home), ownership of housing (under housing services), financial services including insurance. Housing captures only urban housing and excludes rural housing. Even in comparison with the developing world, India’s proportion of food is very high with relatively lesser weight given to housing and transport services.
Food eating more than its share
India’s importance to food in its inflation basket, and more importantly uncooked food in the form of cereals, pulses, oils, spices and milk, is perhaps the highest. While the Philippines has a higher share of total food, the difference is from ‘food away or eating out’. Notably, our inflation mix misses ‘eating out’ or food from restaurants.
If the GDP composition includes ‘trade, hotels etc’, then the inflation basket warrants inclusion of the same. And this is not difficult to compile being a part of GST. The CES 2011-12 survey points out that most food groups had suffered a decline in share over the 18-year period (FY94-FY12). The decline was steepest for cereals, which had halved over the period for both rural and urban India. The share of vegetables had also fallen with beverages being the only exception which rose over the period. Notably, the decline is also evident over the 7-year period from FY05-12 which positively suggests that the current weights need to be revisited.
Many EM (emerging market) countries also have reasonable importance given to ‘food away from home’. Several EM countries review the weights every five years while some countries review every year.
If the target of 4℅ needs to have sanctity and connect with the audience for whom it is intended, it needs to capture their spending patterns more appropriately
Composition of Sub-groups
Over the last 10 years, India’s per capita GDP and private final consumption expenditure (PFCE) have more than doubled which warrants a review of the consumption pattern. In addition, whether items like firewood need to have a 2% weight, whether doctor’s fee and hospital & nursing charges should account for only 13% and 7% respectively of the total health costs, whether items like horse cart fare, cow-dung (albeit small) must feature in the basket need to be assessed.
Market Intervention, Subsidies
The retail price of food (especially cereals, sugar) has been held down because of the role of the Public Distribution System, which provides foodgrain at subsidised prices, and in which the pandemic period provision of some free foodgrains has also played a role.
Market intervention and export caps have aided in keeping domestic food prices contained. The rural employment programme (MNREGA) helps offset some of the imbalances, especially during the non-farming season. While subsidies are perhaps necessary for an economy like India, it also comes at a cost of underplaying the demand and thus lower inflation, and fiscal cost which translates into higher borrowing.
Housing Ownership, Costs
In contrast to food, India’s share of housing in its retail inflation is relatively lower. The inflation index comprises only urban housing as the methodology includes only rent, noting that there is a negligible number of rental dwellings in rural areas. This conclusion itself may warrant a check as the rural dynamics have changed over the decade. Also, the index excludes housing ownership costs and assigns negligible importance to maintenance and utility costs.
Cost of real estate ownership differs in different parts of the country and unless ownership costs are captured, the index will underestimate the divergence in cost of living across the country. The index values are published statewise and for rural/urban separately. For a diverse country like India, housing costs if captured adequately will help price the labour cost appropriately and attract the right talent. It is interesting to note that many EMs have a high share of housing within their CPI Index.
Transport, Communication
Being an importer of energy, the lower relative proportion of motor fuel undermines the impact of energy inflation. Besides, India’s CPI derives a moderate contribution from the ownership and maintenance cost of vehicles (similar to housing). With increasing private vehicle ownership, capturing the complete cost of ownership of a vehicle (both private and commercial) is key to measuring the real cost pressures.
CPI vs WPI
Age-old debate centres around whether CPI is a better measure or WPI (Wholesale Price Index) is a more representative and leading indicator of inflation.
CPI is based on a survey of different retail markets. WPI, by contrast, is derived from data on the bulk sale of commodities at the first point of transaction: ex-factory level for manufactured products, ex-mine level for mineral products and mandi level for agricultural products. But WPI inflation has been higher than CPI for a while now, so it could be asked why past WPI increases have not already been reflected in the CPI.
Aside from the specific commodities (foodgrain and fuel) for which government policy clearly has a proactive role, what could explain this discrepancy? The structural construct, of course. WPI does not include the services component while CPI does not face the direct impact of the rise in crude prices. In addition, the weightage of food is clearly lower in WPI. While producer inflation is not the perfect metric to look at, the reasons for the divergence in trend need to be pondered as it gives a prospective direction to consumer inflation.
When shipping costs rise, the local-currency price of imported goods goes up almost immediately, with 90% of the increase transmitted within two months. After a further two months, the shipping-cost shock is passed through to local producer prices. The rise in consumer prices, however, is more gradual and protracted, reflecting transmission through the domestic supply chain by importers, producers, intermediaries, and eventually retailers.
India’s wholesale price inflation, which does not capture services, after having been at double digits for more than a year has retracted in the last two months. It is noticeable that even if WPI declines, CPI may not decline as sharply if producers do not pass through the benefit as the pass-through of the stress in costs was incomplete in the first place. Therefore, both indices have presented only a partial story of the real picture at all times — either overstating or understating the true picture.
WPI inflation has been higher than CPI for a while now, so it could be asked why past WPI increases have not already been reflected in the CPI
Are we capturing it all, and right?
Giving a low weightage to recreation reduces the discretionary component of the inflation index, thereby lowering the efficacy of measuring policy impacts. Furthermore, the rural-urban divergence also needs to be examined as rural households are anecdotally consuming more services than in the previous decade.
Food and energy are the two key direct culprits plaguing global inflation today. But slowly and steadily the pass-through to services and other components has led to more broad-based pricing pressures across the world. Globally, food prices led by supply chain disruptions have risen sharply and India too had faced the impact viz, oils. However, when comparing India’s inflation basket with the rest of the world, clearly, India could be under pricing its inflation currently with less impact from energy and pass-through of input costs into services. The risk from over-pricing may be limited as the RBI tends to “look through temporary effects”.
While it may be too early to conclude if disinflation (decrease in inflation) trends have set in, it is not too late to revisit the structural composition of the nominal anchor. If the target of 4% needs to have sanctity and connect with the audience for whom it is intended, it needs to capture their spending patterns more appropriately.
If the GDP composition includes ‘trade, hotels etc’, then the inflation basket warrants inclusion of the same. And this is not difficult to compile being a part of GST
In the journey of targeting to become a $5-trillion economy, the RBI’s support in the form of ‘the’ appropriate interest rate to encourage saving and investment and promote credit growth is critical. And for that, the ‘underlying’ nominal anchor needs to be captured right. A shift from CPI to PCE like the Fed could also be considered. PCE will capture the construct of CPI with the data sourced from producers and sellers, blending CPI and WPI.
An inflation-targeting central bank like ours should have a credible inflation measure. Whether the structure of the current inflation is sufficient or deficient will only be known if it is put to test. Like every other key fiscal or monetary parameter, this too needs a check. It is time to review the anchor.
(The author is Economist, Equirus Group)
