Inflation: RBI Is Right on the Course!

The monsoon winds that hit the western coast of India bang on the due date have, true to their tradition, brought good tidings: the month of June was a witness to two good things that happened on the monetary front. First, the most important: inflation has dipped to a 13-month low of 4.28% for the week ended June 9, as against 5.29% of the corresponding week of the previous year, from a high of 6.56% as on March 17th of this year. And all kudos to the Reserve Bank of India (RBI) for so splendidly taming it, that too, in such a short span.

One of the notable contributors to checkmating the rising inflation is RBI’s deliberate and conscious decision to withdraw from its currency market interventions that has seen the rupee appreciate by about 9% since March. Thanks to our liberalized and globalized economy, an appreciating rupee has broken the inflationary spiral. It has made the domestic prices fall in line with global prices by virtue of ‘import-parity-pricing’. Its impact is visible even in domestically manufactured goods such as steel, when producers invoiced their prices by multiplying international prices by the prevailing exchange rate. Similarly, the prices of raw material of different industries have also fallen considerably along with the fall in dollar price, although there was a lag of about 8-9 weeks in the fall in prices of their ultimate end products. An appreciating rupee has also resulted in a dip in exports, which means a fall in demand for the domestically manufactured goods, and which in turn means a fall in domestic prices. Over and above all this, an appreciating rupee did a fat lot of good for imports: they have become cheap.

That aside, the banning of exports and trading in futures of certain agricultural products by the government has, as claimed by some, had its own impact on the falling prices, though the measures, as such, are questionable. The other monetary policy initiatives of the RBI such as hike in interest rates and tightening of liquidity by rising CRR, will of course, take a longer time to impact the price behavior. But, they can act as good deflators of ‘expectations’ and thus could curtail further raise in inflation. Nonetheless, the inflation has of course been commendably brought under control. However, the aam aadmi on the street is not willing to accept this claim and, perhaps, for valid reasons, since he is not experiencing any fall in the price of vegetables, fruits, milk, and other agricultural commodities that matter most to him.

This intriguing phenomenon can, of course, be explained: our practice of estimating inflation based on Wholesale Price Index (WPI)—as against the global practice of estimating inflation based on Consumer Price Index  (CPI)—is the culprit. It is being argued for quite sometime that the WPI is a poor measure of inflation. It is not that the RBI does not work out CPI, but there are many instances where a sizable divergence between its WPI and CPI is noticed. And, secondly, the CPI data comes quite late. May be, that is one reason why we, despite knowing its weakness, continue to use WPI to measure inflation. But, there is another strong weakness in the WPI: it does not reflect the growing importance of the services segment that has in the recent past occupied more space in the consumption basket of the citizens. Yet, we continue to rely on the WPI for estimating inflation and on the thus calculated inflation for many of our monetary decisions.

It is against this backdrop that what the governor of the RBI said—“We are doing technical work on computing a harmonized Consumer Price Index and we are in consultation with the government in this regard”—has emerged as the second most important event that June witnessed happening on the monetary front. Indeed, the present governor has been voicing his concern about this issue for long and it is pretty heartening to see it taking a concrete shape today; more so when the very inflation dynamics are fast changing in the globalized economy, where inflation, too, is being exported/imported. 

The RBI’s realization that an ideal “measure of inflation should cover the entire gamut of goods and services being purchased by a consumer in the domestic market and should represent the entire spectrum of the population of the country” is quite in time, for when the world is fast moving towards the ‘expectations’ theory in understanding the behavior of the aggregate economy, we must at least have a dependable index to measure inflation reliably. Similarly, construction of a single CPI cannot be a good representation of the consumption pattern of the rich and poor, urban and rural, or for that matter the consumption in two different geographical locations of India—such as Punjab and Bihar—where the divergence is quite huge. When the mature economies are factoring ‘core inflation’ in their management decisions, it should be pretty encouraging for our businessmen to know that the RBI will soon come out with a Harmonized Consumer Price Index. 

While it is a good sign of what is in store for the future, the battle is not over. For, inflation and its measurement are as old as economic thought itself, and they continue to daunt mankind forever.

(July, 2007)