The first set of data using the new monthly Wholesale Price Index (WPI) for October, replacing the weekly series, was released on Friday. The long-recommended move to the new monthly series has met with approval from many commentators and analysts. The rationale for this change is that weekly inflation data is noisy and may end up distorting policy decisions. The new monthly data is expected to reduce volatility—in both measured inflation and in the response of markets to that data. To begin with, it definitely makes sense to replace weekly with monthly inflation, whatever the series. No question.
Also See Highs and Lows in WPI Inflation (Graphics)
With regard to the markets, moving to monthly data will reduce noise trading. Financial markets always want more data, since that generates more trading activity. The monthly report will “remove a source of market volatility”, as chief statistician Pronab Sen stated in Mint (7 November). However, unless securities transaction and similar (Tobin type) taxes are imposed to discourage socially undesirable high-frequency trading, the markets will find something else to trade on. Taxes on trading can be imposed in a revenue-neutral manner. The revenues can be used to finance socially desirable expenditure such as the National Rural Employment Guarantee Act and similar schemes—instead of allowing these expenditures to bloat the deficit and harm the economy, as has been the case.
However, the more important issue is not whether the new WPI will significantly reduce market volatility, but whether it will reduce volatility in inflation. A detailed examination of existing WPI data indicates that most of the volatility is across months, not intra-month. The accompanying Table documents the intra- (fiscal) year highs and lows for WPI using both monthly and weekly data. The monthly WPI level used here is the last week’s observation for that month (every month having four and occasionally five weeks of data), not the average monthly value. As can be seen from the Table, if we compare the highs and lows for the year in the monthly series with that in the underlying weekly series, there is hardly any difference. The weekly series is just a bit more volatile. Judging from the timing of the highs and lows in WPI, one can conclude that much of the variation in WPI inflation arises from shocks to the price level that last for several months at least. For instance, due to the hike in the administered price of petroleum products, WPI rose above 12% in July 2008. In other words, the major volatility in WPI inflation has been intra-year for different months, not intra-month for different weeks.
The real improvements in data collection and their use in policy need to be in a different direction. The Consumer Price Index (CPI)—used as “the” measure of inflation across the world—must replace WPI. By contrast, the policymakers here claim to look at all measures, but WPI is clearly paramount. On several occasions this year, the Reserve Bank of India and others have stated, without generally specifying which precise measure, that inflation is expected to rise to about 5% by early 2010. Clearly, the default reference to inflation is to WPI, since CPI has been well above 5% over the last year and more.
The heavy reliance on WPI in formulating monetary policy at present partly rests on a misunderstanding of the consequences of the failure of direct inflation targeting, or DIT. Whether or not a country follows DIT, CPI should still be paramount. Good monetary policy needs to both control inflation and stabilize output. The well-known Taylor rule sets the federal funds rate based on both inflation (with typically a 2% CPI target or equivalent) and the ratio of actual to potential real output, or the related output gap. In India, WPI inflation is closely correlated with the output ratio, since the bulk of it is manufacturing products. So when the economy is weak, WPI inflation tends to fall a lot, unlike CPI.
A single-minded focus on CPI, as in a DIT policy, would clearly have been disastrous in recent months. It would have led to tightening in late 2008 when industry was down in the dumps, and early this year, when WPI was falling sharply, although CPI was high and rising. To its credit, RBI did not do so. However, it does not follow that policy should respond to WPI. When there is weakness in the economy that warrants monetary easing, that weakness can be captured by the output gap term in a Taylor-rule type policy, which also takes into account CPI inflation. Insofar as there are difficulties in measuring the output gap in real time, it can be proxied by some statistic based on industrial production data. The need for monetary policy to also stabilize output does not imply that WPI should be used in monetary policy.
The recent proposed changes in data collection and the switch to monthly reporting of WPI are welcome and overdue. However, choosing the right price index is far more important than the frequency of measuring inflation. Improving upon the wrong measure of inflation (WPI) will tend to delay the switch to the right measure (CPI). Unfortunately, India is the only country that does not give primacy to CPI. The justifications offered for not doing so are flimsy and need to be discussed separately.
Graphics by Ahmed Raza Khan / Mint
Vivek Moorthy is professor of economics at IIM, Bangalore, and Sunil B. Shankar is a research associate, also at IIM, Bangalore. Comments are welcome at email@example.com