CPI Conundrum

Updated: Oct 5 2013, 10:10am hrs
Soon after taking over as RBI governor, Raghuram Rajan sparked off a debate on whether inflation based on consumer price index (CPI) should be the "nominal anchor" for guiding monetary policy. While Rajan has clarified that RBI has not yet decided on moving to inflation targeting with CPI as the sole index, he has voiced concern over a "sticky and high" CPI inflation, which was making people reluctant to invest in fixed income assets like bonds and bank deposits, and instead shifting to gold and real estate. This was not just lowering household financial savings rate but also widening the current account deficit, weakening the rupee and posing a risk to growth revival. While Rajan has set up a committee to look at the nominal anchor, experts have started pointing to a number of flaws in the new CPI and the dangers of relying on it to frame monetary policy.

Government data shows while GDP growth has fallen sharply to 4.4% in Q1 of this fiscal from 9.3% in the entire FY11 and RBI's benchmark repo rate has stayed firm at over 7.25% in the last two years, WPI inflation and GDP deflator have been more responsive than CPI inflation. The core WPI inflation that mirrors demand for manufacturing products has fallen from close to 7% in Jan 2012 to 1.9% in August 2013. In contrast, the core CPI inflation that should capture both manufacturing and services has eased from 10.4% in Jan 2012 to 8.2% in August. What is disturbing, the gap between CPI and WPI core inflation rates have widened.

What's surprising, WPI food inflation has outpaced CPI food inflation since July even though logically price rise should be more steeper at the retail level especially in times of supply shocks as we saw for onions. Even the CPI rural and urban inflation rates have clung close to each other for several months between September 2012 and March 2013, which defies logic considering the weighting of food, manufacturing and services items are significantly different for the two sub groups. Economists say the new CPI, launched in April 2010 and start giving the inflation reading from April 2011, is yet to stabilise. While central banks in most countries have switched to CPI as a benchmark for monetary policy, it may be too premature for RBI to toe that line even though retail inflation cannot be totally ignored.