Do you know your inflation

Updated: Feb 15 2002, 05:30am hrs
Now that sugar is decontrolled, its price will hopefully better reflect the demand supply situation. That is, if prices start going up, we can interpret it as a signal of relative scarcity, and conversely falling prices would signify a surplus. The decontrol of sugar is predicated on the successful operation of the futures market. Let us suppose that sugar (spot) prices are stagnating, but sugar futures prices start flaring up. The rising prices of sugar futures contracts, which are actually tradeable securities, signal relative scarcity of the commodity sometime in the future. Hence anyone just tracking the spot price of sugar will fail to use the crucial information contained in those rising prices of sugar securities. Of course no one in the sugar business would be foolish to ignore futures prices. But the bigger message of this example is that securities prices are important constituents of a broad price index.

Inflation is the rate of change of an index. The index (on a scale of 100) is a weighted average of a bunch of prices of various goods and services. The weights are fixed. This basket of goods and services is selected so as to be comprehensive and representative. Different baskets lead to different indices, such as the wholesale price index and the consumer price index. Of course if all the prices in a particular basket move together, that is, if they are all highly correlated, then only one or two prices will suffice. It is then simpler to track only one price, as a measure of inflation. But in general, omitting some goods or prices from the basket will be misleading. The present CPI does not contain steep decline in the cost of telephone calls. So maybe it is overstating inflation. Of course, it all depends what you want to do with the inflation numbers. Different people have different uses for an index. Politicians might want to track only onion prices. Wage bargainers might want to focus on the CPI. The Economist magazine tracks the price of Big Mac. But monetary authorities, who have to strike the right balance between growth and inflation, would want to keep track of a more general transactions price index, which can capture the broad purchasing power of money.

How broad an index should the Reserve Bank of India use Should it use only the WPI basket of prices, or should it also include asset prices Currently the WPI based inflation rate is at historic lows, around 1.3 per cent, causing the RBI to express a concern that it might be too low and might be hurting growth. This concern means we can expect reflationary policy in the near future. CPI based inflation is however at 5 per cent. But meanwhile most asset prices in India are perking up. By assets I mean financial assets stocks, bonds, gold and foreign exchange. The bond market index has risen by 60 per cent in the last three years, with steep gains in the last six months alone. Gold prices are at a five year high. The dollar keeps getting dearer, but of course not as much in inflation and trade adjusted terms. Monetary policy is basically about maintaining a low to stable inflation and keeping the economy close to full employment and a high growth path. Inflation targeting has meant looking at prices of goods and services only.

But there are several reasons, especially after the phenomenon of stock market dotcom boom and bust, for central banks to keep a tab on other prices too. Firstly inflating asset prices creates a wealth effect. Consumers start spending more as they feel wealthier, and high share prices induce firms to increase investment spending exuberantly. Thus flaring asset prices signal future CPI or WPI inflation. Secondly, to the extent that assets create income flows in the future, their inflated prices means that more consumption spending is going to be enabled in the future. Thirdly, to the extent that asset price increases can lead to a bubble, which when it bursts, can initially cause excessive borrowing followed by bankruptcies and possibly recession. A collapse in real estate or stock values, leaves most loans (against real estate or shares) without adequate collateral support and hence a potential banking disaster (like Japan, East Asia). Of course inflating asset prices might not be a bubble at all, and might reflect fundamental economic growth. Fourthly, asset prices also play a role in the monetary transmission mechanism. Lastly, as central banks set interest rates which affect the functioning of asset markets, it makes sense to incorporate them in monetary policy.

Does that mean RBI should also focus on stabilising asset prices Of course not! Incorporating asset prices into monetary policy, means squeezing the information juice out of them fully. Maybe the asset price rally is a leading indicator of some inflation to come

Ajit Ranade is Chief Economist, ABN Amro Bank, India