Headline : BASICS: Understanding inflation
Why in News?
- India’s headline inflation measured by the Wholesale Price Index (WPI) rose 5.77% on a year-on-year basis to a 54-month high in June 2018.
What is inflation?
- Inflation is defined as a sustained increase in the general level of prices for goods and services in a county, and is measured as an annual percentage change. Under conditions of inflation, the prices of things rise over time.
- The value of a rupees is expressed in terms of its purchasing power, which is the amount of real, tangible goods or actual services that money can buy at a moment in time. When inflation goes up, there is a decline in the purchasing power of money.
- Put differently, as inflation rises, every rupees you own buys a smaller percentage of a good or service. When prices rise, and alternatively when the value of money falls you have inflation.
How inflation are measured?
- In case of India, there are two indices that measure inflationary trends (the movement of price signals) within the broader economy:
- Consumer Price Index (CPI): CPI captures changes in prices levels at the shop end, and is, thereby, reflective of the inflation experienced at the level of consumers.
- Wholesale Price Index (WPI): Wholesale inflation, measured by WPI, tracks year-on-year inflation at the producer or factory gate level, and is a marker for price movements in the purchase of bulk inputs by traders.
- WPI vs CPI baskets:
- The two indices differ sharply in the manner in which weightages are assigned to food, fuel and manufactured items, as well as at the broken-down level of these segments.
- The weightage of food in CPI is far higher (46%) than in WPI (24%). Also, WPI does not capture changes in the prices of services, which CPI does.
- CPI follows WPI:
- As in any imperfect market, changes in prices at the producer level get transmitted to consumers, mostly with a lag and, in some cases, not to the full extent of the impact at the producer level.
- So, while a higher WPI reading can be an aberration at times, a steady upward surge in WPI reading is most certainly an indicator of inflationary pressure entrenching itself within the broader economy and getting eventually reflected in the CPI numbers.
Inflation and growth:
- Based on studies of a wide range of countries over the years, economists have broadly concluded that the inflation-growth relationship as being significantly negative if inflation is above the threshold value, and insignificant or significantly positive if it is below the threshold value.
- Also the threshold values of inflation in developing countries are higher than in developed countries i.e. in developing countries it is at 7-11 per cent compared to 1-3 per cent in the developed countries.
- Indian context:
- A study examined “threshold effects” in the relationship between inflation rate and real GDP growth. It concluded that inflation threshold existed for India, and this implied a non-linear relationship between inflation and growth.
- It suggested that there exists a statistically significant structural break in the relation between output growth and inflation in the 4% to 5.5% inflation range, above which inflation retards growth rate of GDP, and below the threshold level, there is a statistically significant positive relationship between inflation rate and growth.
- The paper concluded that substantial gains can be achieved if inflation is kept below the threshold.
- This paper came in the immediate aftermath of the stimulus-fuelled growth strategy resorted to by most countries, including India, in the aftermath of the global financial meltdown in 2008. Also, importantly, this paper used WPI inflation in its empirical analysis.
- After it shifted to the CPI as its main benchmark for mapping policy rates, the RBI has a target to keep consumer-level inflation at 4% (+/- 2%). Any rise in CPI inflation beyond this comfort zone puts pressure on the central bank to hike rates.
Monetary Policy Committee (MPC) and CPI:
- In April 2014, the RBI had adopted the CPI as its key measure of inflation. Prior to this, the central bank had given more weightage to the WPI as the key measure of inflation for all policy purposes.
- Recently a Monetary Policy Committee (MPC), having both government and RBI members, has been constituted which will determine the monetary policy rate required to achieve inflation target as set under the Agreement on Monetary Policy Framework.
- Under the framework, central Government, in consultation with RBI, has fixed the inflation target as 4+/-2% (CPI).
- Thus MPC will be held accountable for its failure to meet the inflation targets if the average inflation being more than the upper level of the inflation target or less than the lower level of the inflation target for three consecutive financial quarters.
The impact of increase in WPI:
- The increase in the WPI headline print might not appear extremely relevant from a policy perspective, however, it highlights the pressure on prices in the economy, and indicates a further rise in retail inflation.
- There are two key concerns here:
- One, that there has been a sustained increase in WPI inflation since the start of the current fiscal.
- Two, that data released by the government last week showed that retail inflation, too, had risen to a five-month high of 5% in June.
- Hike in repo rate: Also surge in WPI numbers can have cascading effect on CPI. So given these trends in the WPI inflation reinforces expectations of analysts that a repo rate hike is likely at the next meeting of the RBI’s Monetary Policy Committee in August.
- Rise in inflation:
- In its last policy review in June, the RBI had indicated that there could be significant upside inflationary risks, thus leading to an increase in prices of commodities, especially food. Though it increased the rates unexpectedly to counter rising inflation at an early stage.
- However, the worry is that the revised inflation projection of 4.8%-4.9% issued by the RBI, could be breached due to rising crude oil prices.
- Impact on economic growth:
- Recently, the International Monetary Fund (IMF), in an update to its World Economic Outlook (WEO), said the Indian economy will grow slower than what it had estimated, because of higher crude prices and faster interest rate hikes.
- In the fresh update, the IMF trimmed India’s growth projection for 2018-19 by 10 basis points to 7.3%. For 2019-20, IMF cut its projection by a sharper 30 basis points to 7.5%.
- Reflecting this view, Morgan Stanley, noted that the likely rise in crude oil prices that could put pressure on growth, an election cycle that brings its own set of uncertainties, and an upward pressure on inflation from food price hikes that sees the RBI hike rates further, are among the top risks to Indian equities.