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Column : Which inflation is RBI targeting?

Forget WPI, CPI, PPI or core inflation, the GDP deflator is the best?and this is falling steadily.

In the last one and a half months, a fierce debate is raging regarding the validity of RBI monetary policy actions against the backdrop of inflation numbers. RBI has given a new twist to this debate with the Governor recently espousing the need to develop a producer price index (PPI) and reiterating its position that increase in interest rates by RBI alone cannot explain the current investment slowdown. No prizes for guessing that we at Ficci would be on the other side of the debate. However, our endeavour in this piece is not to re-emphasise the relevance of a rate cut, but to open up a new area of debate by focusing on the rationality of the RBI policymaking.

First, the arguments on inflation. As per the RBI logic, notwithstanding the recent moderation in core inflation, the persistence of overall inflation, in particular at the retail levels, reflects sticky inflation expectations and poses a sharp upside risk to inflation in the coming months. This same logic has also been propounded by some economists of late but we find this analysis incomplete. The debate over the divergence between CPI and WPI had come up during the late 1990s-early 2000s and also during post-Lehman period while it died down thereafter as the two series converged afterwards. Higher CPI inflation is primarily due to the significant higher weight given to food articles in the basket of CPI components, compared to the WPI.

There could be a counterargument to this, as CPI excluding food prices has been higher as compared with overall CPI in recent times. However, this argument is futile since a more complete measure that includes the price of services would be the implicit deflators used in the measurement of GDP. The construction of these deflators is a relatively complicated exercise, but the end result is a much more representative measure of changes in the value of current output of goods and services. Thus, GDP (factor cost) deflator is a closer replica of the WPI, whereas GDP (market prices) deflator being derived by adding taxes and subtracting subsidies is intuitively closer to a valuation at retail prices, and hence the CPI. The inflation numbers based on GDP deflators (market prices and factor cost) have actually declined and nearly converged during FY12! This trend also shows the divergence debate between CPI and WPI may be misleading. Hence, any inflation prognosis based on purely CPI numbers is incomplete and may result in erroneous policy actions.

Secondly, on the merit of a PPI measure, it must be noted that unlike an inflation-targeting economy (where CPI is the inflation measure for targeting), WPI measure has evolved as the most comprehensive measure for inflation in India. Interestingly, WPI actually encompasses both CPI and PPI, and a rigorous academic exercise may well decipher a PPI construction from WPI itself. We believe the concept of core inflation may be a de facto measure of PPP, since it excludes the more volatile food and energy components relevant to a consumer. Going by this logic, thus even we measure inflation through PPP, it will not make a significant difference to the numbers.

Elsewhere, RBI emphasises the lack of applicability of inflation targeting in the Indian context?to quote: ?Inflation targeting is neither desirable nor practical in India for a variety of reasons, like food items which have a large weight (46-70%) in the various consumer prices indices are subject to large supply shocks, especially because of the vagaries of the monsoon, and are therefore beyond the pale of monetary policy. An inflation targeting RBI cannot do much to tame a supply driven inflation except as a line of defence in an extreme situation?. The two makes the position of CPI as an indicator of inflation somewhat tenuous.

In short, in the multiple-indicator approach to evaluate inflation, three indicators, viz, GDP (market prices) deflator declined from 10.1% in Q1FY12 to 6.5% in Q4FY12, GDP (factor cost) deflator declined from 9% in Q1FY12 to 6.4% in Q4FY12 and core inflation (currently at around 5%) clearly points to receding inflationary pressures. Thus, to use CPI as a policy tool may be leading RBI in wrong policy direction.

A more fundamental question of the growth-inflation link remains unsettled as yet in contrast with the rather one-sided commentary from RBI. RBI has argued recently, as indeed held by most other central banks too, that a high inflation rate eventually interferes with an economy?s efficiency and that inflation rates over and above a ?minimum threshold? impedes growth. RBI believes that the threshold inflation rate in India is around 5%, i.e. with inflation rate above this range, one would expect growth rate to be affected or more specifically decline. Based on a panel data on inflation (CPI) and per capita GDP data for emerging economies during 2001 till 2010, we found that the postulated evidence of a negative causation is not particularly strong with a correlation coefficient of -0.31. Also, a study by NCAER shows that the correlation between CPI inflation rate and GDP per capita growth rate for the period 1970-71 to 2010-11 is only -0.11. Interestingly, if we only take 2010, there is a positive association between growth and inflation. The examples of Turkey, Brazil and Malaysia provide credence to this positive causation between the two.

Finally, the spectre of drought in India (as well as elsewhere) and impending fuel price hike are now being put forward as upside risks to inflation in coming months. It may be true to some extent (even though the Reuters Commodity Research Bureau Index as on July 24 2012 is still lower by 37% as compared to the peak levels witnessed in July 2008, after touching record lows in June 2012), but any increase in food prices attributable to weak monsoon calls for decisive policy actions to kick-start the economy, rather than using it as an argument to wait and watch.

Rajiv Kumar is secretary general, Ficci. Soumya Kanti Ghosh is director, economics & research, Ficci. The authors thank the Ficci economics team. Views are personal

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