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Posted by: Deepa Vasudevan on Tue, Nov 19th, 2013

CPI and WPI: Tough to choose one over the other

The Wholesale Price Inflation (WPI) index has historically been the price index monitored by Indian policy makers. As a measure of inflation, WPI has two critical shortcomings. First, it does not cover the price of services. This means that WPI does not capture changes in prices of house rent, medical check-ups, hospitalization, mobile telephony services, school fees, or any of the services that collectively make up at least one third of the average consumer budget.  Second, WPI is made up of wholesale prices, rather than the actual retail prices at which items are purchased in the market by the end-customer. Obviously, WPI inflation was never a good proxy for the cost of living, but the fact that it was compiled and released on a weekly basis made it the inflation index of choice[1].

 

The importance of WPI has not reduced, despite the availability of the new monthly Consumer Price Index (CPI) from January 2011. The Central Statistics Office compiles separate CPI indices for the urban and rural population, as well as a combined national level index. The new CPI represents the retail consumption basket much better than WPI, because it covers both goods and services, and the weight assigned to each item is based on a survey of actual consumption expenditures[2] (see Pic 1). Additionally, it is based on retail prices culled from the market, so it includes taxes and duties actually paid by consumers.

 

Pic 1: Composition of WPI and CPI

 

Pic 1: Composition of WPI and CPI

 

Source: CSO

 

Yet policy makers are slow to discard WPI for CPI. The main reason is its newness, or the fact that there are only 19 data points for CPI inflation (from Jan 2012 to Oct 2013). Statistical tests need at least 30 observations to be accurate; and the available data set of CPI is too small for rigorous analysis. For instance, one cannot run a regression to measure the impact of interest rates on prices and GDP; as a result RBI cannot use past trends to assess the impact of policy changes on CPI.

 

The two inflation indices do not always move together: this creates confusion about inflation trends. On an average, the differential between CPI and WPI inflation is about 3%. However, during March 13- June 13, it widened to a massive 4.7%, as WPI fell much faster than CPI (Pic 2).

 

Pic 2: CPI, WPI, and their differential

 

Pic 2: CPI, WPI, and their differential

 

Source: CSO

 

The ex-RBI governor, Mr.D.Subbarao, recently pointed out that the difference between CPI and WPI was the result of “statistical differences stemming from coverage, classification of items and the relative weights of their constituents”[3]. Much of the divergence is explained by the relatively higher weight of food items in CPI. Since inflation in recent years was largely caused by food prices, retail inflation tended to be higher than wholesale inflation. RBI studies have shown that WPI and the old CPI index for Industrial Workers (known as CPI-IW) moved together in the long run[4]. Thus it is possible that the differential with the new CPI will also narrow over time. But in the short run both indices will need to be watched carefully.

 

As market watchers scrutinize the two indices for clues to policy action in the December 2013 review of monetary policy, two points must be noted. First, retail prices tend to lag wholesale prices because producers pass on price rises to consumers after some time[5]. If demand is strong, price hikes can be passed through easily. But in a situation of weak demand, producers may opt to hold prices constant. But whatever the demand situation, a consistent rise in WPI would force producers to increase retail prices.  In October 2013, WPI inflation reached 7%, the highest level this fiscal year. If this rise is sustained, CPI (which is already 10%) would rise too in the coming months. This will make it tough for RBI to lower interest rates in the near future. Second, India is one of the few emerging economies facing inflation; most are struggling to manage deflation. That food inflation can occur despite a good monsoon clearly indicates that infrastructure for distribution of agricultural produce is weak. Strengthening agricultural supply chains should be a priority; otherwise the country will be caught up in chronic inflation cycles.



[1] Weekly release of WPI was stopped after January 2012. Since then only monthly WPI number are released

[2] The weighting diagrams for the new CPI series have been derived on the basis of average monthly consumer expenditure of an urban/rural household obtained from the NSS 61st  round Consumer Expenditure Survey data (2004-05). Source:CSO, Ministry of Statistics and Programme Implementation.
Available online at http://mospi.nic.in/Mospi_New/upload/brochure_n_cpi18_feb11.pdf

[3] Speech given by Mr D.Subbarao at the Statistics Day Conference, August 30, 2013.
Available online at http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/GSSTD30082013.pdf

[4] An excellent summary of the long run relationship between CPI-IW and WPI is found in a speech by Mr.Deepak Mohanty, Executive Director, RBI, on January 9, 2010.
Available online at http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/IAEDF140110.pdf.

[5] The old CPI-IW was known to lag WPI by one or two months, there is not enough data to estimate a similar lag length for the new CPI.

Ajit Purohit on Mon, Nov 25th, 2013 6:09:48 pm

I feel CPI indices should be taken because it contains food products, which is more volatile than any other.

Deepa Vasudevan on Mon, Nov 25th, 2013 9:54:47 am

Hi Mr. Sreenivasan, Here are some answers to the queries that you have raised - 1. Who decides the weightage of the various parameters that form both the indices? The weights of the parameters of CPI and WPI were decided by the Central Statistical Organization, under the ministry of statistics and programme implementation. The process of changing or fixing weights is complex, usually a committee of experts is set up, some surveys on consumption pattern are carried out, and the experiences of other countries are drawn from. 2. What inflation index do developed economies follow and what are the constituents of the index. Why we as an economy do not follow a single index which will mirror the actual state of affairs rather than have two indices which cause confusion as mentioned in your blog? Developed economies usually have two leading indice - a Purchasing Price Index (PPI) which refers to the prices of purchases made by manufacturers and a consumer price index (CPI). Monetary authorities target CPI, since that reflects the actual cost of living of common man. The PPI is a measure of cost of producers, so it may be used to study external competitiveness of a country. For example, if PPI for China rises, it may not be able to export as cheap as before. So it is impossible to have one index for any country. The key issue here is to ensure that the index is computed accurately, has good coverage, and is released in a timely manner.

Pramod Bajaj on Wed, Nov 20th, 2013 3:14:52 pm

Inflation is one of the highly debated figure for the Financial Planners for calculating the Goal amounts. WPI figures don't seem to be realistic for Investor's consumption and Goals for services like health care/education etc. However CPI figures also seem to be very high for Goal value calculations as its use make Goals highly ambitious. I feel that it is safer to consider CPI figure so as to take care of various life style consumption in future which we may not be able to visualise now.

chandrashekhar on Wed, Nov 20th, 2013 11:59:28 am

CPI will differ in rural & urban cases.as in rural vegetable cost is less compared to urban. In Urban area Service cost also get higher whereas in rural area service cost is negligible.RBI should consider CPI for deciding interest rate or rather allow to issue CPI linked bond for senior citizen.Higher CPI became common phenomena.due cascading effect of diesel prices rise every month.

Vikram Sreenivasan on Wed, Nov 20th, 2013 10:02:47 am

Hi Deepa, Some points to ponder. Who decides the weightage of the various parameters that form both the indices. Also, as a major part of CPI is food products which are relatively more volatile and that of WPI is mfg. products which is relatively less volatile, there will always be a sizable difference between CPI and WPI. What infaltion index do developed economies follow and what are the constituents of the index. Why we as an economy do not follow a single index which will mirror the actual state of affairs rather than have two indices which cause confusion as mentioned in your blog.

Harshad Ashar on Wed, Nov 20th, 2013 7:59:49 am

The article is titled as tough to choose. In fact even today for many of us it is tough to understand. U have made it very easy to understand. Thanks a lot for detailed information and also for related online reference.

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