Inflation rate and the blemished calculations

Saturday, May 24, 2008

"Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair." - Sam Ewing.

Official calculations indicate that inflation is hovering at 8%, the actual effect seems to be far more than what it is. The current method of calculating the inflation rate doesn't give the complete picture of our economy. India's method of calculating the inflation rate has some 'serious flaws' in it. India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. "WPI does not properly measure the exact price rise an end-consumer will experience because, as the name suggests, it is at the wholesale level." How? Its evident from the dilemma of the UPA government. Oil is costing $130 per barrel, twice what it was a year ago, and India is importing 70% of its oil needs. In spite of dramatic rise in oil prices, government is not willing to raise the oil prices because of its effect on already rising inflation rates. "Under the present system of subsidised domestic pricing for petrol, diesel, kerosene, and the LPG, the country’s public sector oil marketing companies (OMCs) lose more than Rs.500 crore a day. If domestic prices for oil products rise, inflation, which is already high, will increase even more. With the 15th general election due within a year, the political consequences are feared. But if prices are left untouched, the fiscal deficit will increase, again with inflationary consequences"[The Hindu]. Thus government can control (just) the inflation index and say that "rates are within our limits and government need some time", but in reality prices are hitting the sky. Food prices have reached the historic high and common man is in a huge dilema. Common man, to whom inflation affects the most, doesn't even understand what inflation actually means in broader perspective, but he only feels the heat of inflation when he is forced to pay some extra bucks for his daily bread.

Its high time for India to retrospect its (inflation calculation) basics. Inflation index should focus on common man and not on the wholesale prices. India is the only major country that uses a wholesale index to measure inflation. Most countries use the Consumer Price Index (CPI) as a measure of inflation, as this actually measures the increase in price that a consumer will ultimately have to pay for. Some economists believe that government of India urgently needs to change its method of calculating the inflation rate. There are some advantages of using WPI and Consumer Price Index to measure the inflation, but there are large number of drawbacks using these methods.

Here is the quick understanding of the terms [source]:

WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks.

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. CPI is a fixed quantity price index and considered by some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

Why no to Wholesale Price Index (WPI)? [rediff]
  1. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy.
  2. More than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view. For example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation.
  3. WPI does not properly measure the exact price rise an end-consumer will experience because, as the name suggests, it is at the wholesale level.
  4. The WPI ignores services for which the consumer pays a lot out of his monthly budget.

Why no to Consumer Price Index (CPI)? [wiki accessed on 24th May, 2008]
  1. Consumers' expenditure abroad is usually excluded; visitors' expenditure within the country may be excluded in principle if not in practice.
  2. The rural population may or may not be included.
  3. Certain groups such as the very rich or the very poor may be excluded.
  4. Saving and investment are always excluded, though the prices paid for financial services provided by financial intermediaries may be included along with insurance.
  5. Black market expenditure and expenditure on illegal drugs are often excluded for practical reasons, although the professional ethics of the statistician require objective description free of moral judgments.

For some extent CPI looks better than WPI because,
  1. It's a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation.
  2. CPI is a fixed quantity price index and considered by some economists as a cost of living index, which means it can give some idea about cost of living.

So, which method should we follow?

I feel that, neither WPI nor CPI can clearly give the picture of inflation in a country. They have more drawbacks than the advantages. However, these methods can be improved to reflect the inflation in an acceptable way. For example,
  1. India constituted the last WPI series of commodities in 1993-94; but has not updated it till now and economists argue that the Index has lost relevance and can not be the barometer to calculate inflation. The base year should be changed appropriately, say 2004-05.
  2. There are many 'not so important' commodities listed in the WPI calculation. All unimportant commodities can be dropped from the list and some important commodities should be introduced in the list.
  3. Currently there are only 435 commodities listed in the WPI Calculation. This number is meagre considering the size of our economy. This number should be increased significantly or better if it's doubled, so that the base for calculation will be much wider.
  4. In case of WPI, the index is made available weekly, this has huge impact in the market and might give raise to misleading speculations. So WPI index should be released once in a month or at least for every fortnight.
  5. The accuracy in the pricing should be of highest standards so that even slightest variations can be avoided.

You can add more to the list. But one thing is clear, we definitely need reforms in calculating the inflation rate. Inflation doesn't affect the profligate consumer, but it has the huge potential to kill common man. A poor who used to get two meals per day may find it difficult to get even a single meal when inflation is hitting the sky.

Related External Links
  1. 10 nations with highest inflation - Zimbabwe's inflation rate has increased 355,000%. In Zimbabwe, A sausage sandwich sells for Zimbabwean $50 million. A 15-kg bag of potatoes cost Zimbabwean $260 million. But then, Zimbabwean $50 million is roughly equal to US$ 1!
  2. Hindustan Times - Fuel hike inevitable, inflation crosses 8%, At $135, oil set to put inflation on fire - Looks like oil is the fuel for inflation too!
  3. Myths about inflation - rediff.
  4. CPI, WPI-based inflation gap widens -Times of India.

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This work by Manjunath Singe is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 2.5 India License. The views and opinions expressed in this work are strictly those of the author and do not represent his employer's views in anyway.