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All about inflation

Whether it falls or rises, both ways it gives sleepless nights to the policymakers.

The term inflation does not need any introduction. Even a layman knows that it’s about rising prices. In economics, it’s defined as a rise in the general level of prices of goods and services in an economy over a period of time. Last year it created havoc when it continuously surged to as high as 13% in August 2008. Then, the central bank kept on increasing the key policy rates to curb it. What was earlier a financial crisis in the US exploded into a full- fledged chaos in the real economies across the countries. The general slowdown turned into recession and it is expected that it will only deepen in times to come. In India we are soon going to experience zero inflation and a temporary negative inflation for some more time. Inflation has two other siblings: disinflation and deflation. Disinflation is a decrease in the rate of inflation which usually takes place during recession. In this case prices still rise but at the lower rate. On the other hand, during deflation, prices actually drop and do not rise at all. So, you may be asking why prices are not falling if this is deflation. We will answer this question later. There are two barometers that measure price rises in commodities. WPI (Wholesale Price Index) and CPI (Consumer Price Index). Most of the advanced economies such US, UK, Japan, France, Singapore and China have adopted CPI as official barometer to measure the inflation except India, where WPI is used for the purpose. WPI measures inflation at each stage of production while CPI measures inflation only at the final stage of production. WPI is often seen as a comfortable tool to take measure against price rise by the policy makers as it gives direction before the commodity actually hits the market. WPI is available on a weekly basis with as short possible time lag of two weeks. In Indian context, WPI uses a basket of 435 commodities out of which ’primary articles’ (food items and non-food items like jute etc.) contributes 98 items, “fuel, power, light and lubricants” 19 items and “manufactured products” 318 items respectively. Further, they have been assigned a weight-age of 22.02%, 14.23% and 63.75% respectively. The biggest shortcoming of the WPI is that it essentially measures the price changes from the production side and not from the consumption side. Moreover, it does not take into account the retail margins thus fails to reflect the actual price the end consumers pay. It also does not cover the price changes in the services like health care, education, communication, clothes, recreation, rented accommodation and holidays where consumers spend a major part of their income. Last but not the least, out of 435 commodities that the basket encompasses, over 100 are ceased to be important from consumer point of view. On the other hand the CPI is based on changes in prices at the retail level. This is used to measure the cost of living. The government, private sector, embassies, etc employ this index to compute the dearness allowance (DA). Although WPI helps in understanding of the changes in prices worldwide, CPI is known as the best and most well known indicator of inflation. This is right time Indian government should value the benefits of WPI vis-à-vis CPI.

Deepak Tiwari Research Analyst T: + 91 22 4600 0345

March 25, 2009

For Private Circulation only

CPI inflation is used in most of advanced countries including China. The WPI does not give true picture and also does not cover services, besides being irrelevant. Policy making based on it could be misleading.

Now after reading above paragraphs few things arise in our minds. Firstly, this is not the true rate of inflation and thus cannot be compared with that in the advanced countries including China. Secondly, despite the fact that inflation is on the course to be negative, generally prices are not falling. The reason being for the peak inflation of about 13% last year was irrational rise in crude and metal prices. Hence, the correction in their prices is responsible for the imminent negative inflation. Moreover this is a supply side problem. Further, the CPI inflation, known as the best and most used around the world, is still hovering above 10%. It was 10.45% in January 2009, the highest in over a decade. Thus one may doubt that policy making on the basis of WPI inflation which does not give true picture of rise in prices, may be misleading. During deflation consumers postpone their spending anticipating further fall in the commodities prices. Now the question why prices are not falling if this is deflation. The WPI inflation declined to 0.44% during week ended March 7, 2009 week on week basis (wow) while increased by 0.44% year on year (yoy) basis. Except manufactured products that remained flat on wow basis, other items declined marginally. Fuel, power, light and lubricants plunged by 6% whereas primary articles and manufactured products increased by 4.4% and 1.3% yoy. When inflation reaches zero, the prices on goods will become stagnant. And when inflation will turn negative, we will see the actual fall in prices, which is likely to happen after 2-3 months from now. Moreover some economists aver that it would remain negative till December. The International Monetary Fund (IMF) has projected an average inflation rate of 1.9% for India in 2009-10. If we consider CPI for Urban Non- Manual Employees (UNMI) inflation increased by 10.4% in January 2009 over the corresponding period in the previous year. Food, beverages and tobacco zoomed by 14%, fuel and light surged 8%, housing zipped up 5.8% while clothing etc. increased by 2.4% yoy during the period. Meanwhile, economists are arguing if it’s disinflation or deflation. No matter what we term it, situation is quite bleak. This is time the central bank takes some monetary measures and cut rates ASAP. Changes in Wholesale Price Index (WPI) As on March 7, 2009 All commodities Primary articles Fuel, Power, Light & Lubricants Manufactured Products Changes in CPI (UNME) in January 2009 General Index ( all groups) Food, beverages, tobacco Fuel and light Housing Cloth., bedding and footwear Miscellaneous
Sources: CSO, Artha Money

WoW % Change -0.44% -1.05% -0.77% 0.00%

YoY % Change 0.44% 4.38% -5.95% 1.32%

Fall from the high -6.21% -2.89% -15.62% -4.41%

YoY % 10.4 14 8 5.8 2.4 9.7

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March 25, 2009

For Private Circulation only