Method of computing GDP deflator misleading: RBI

Do you disbelieve the near-deflationary scenario painted by the GDP (gross domestic product) deflator? You’re in good company—the Reserve Bank of India (RBI) is as sceptical as you are.

Inflation, according to the GVA (gross value-added) deflator derived from the national income estimates put out by the Central Statistics Office, has been near zero this year. The GVA deflator is perhaps the most comprehensive indicator of inflation in the country, simply because it includes all goods and services.

If true, inflation falling to near deflation levels is a concern, voiced by none other than the government’s chief economic adviser. Fortunately, RBI now tells us the method of computing the deflator in India is wrong.

The central bank’s Monetary Policy Report, released with its monetary policy statement last Tuesday (29 September), says, “In India, to obtain quarterly GVA estimates at current prices from constant prices estimates, WPI (Wholesale Price Index) is widely used for many sectors. This tends to overstate the extent of price decline in the GDP deflator when WPI is in deflation. Services, which account for over 60% of GVA, are not covered in WPI; yet WPI is used as deflator for several services activities such as trade, hotels and restaurants, real estate and transportation.”

That is why, although the GDP/GVA deflator is supposed to be the widest measure of inflation in the economy, in India it is not so because of the way it is constructed. In other words, the sharp decline in the GDP/GVA deflator is due to WPI having a larger weight in it. In the services sector, inflation according to the GVA deflator was –0.6% in the first quarter of FY 2016. That is unlikely to be correct.

But it’s not just inflation according to the GDP deflator that is in question. The RBI report also says: “The GDP/GVA deflator mirrored WPI movements; this warrants a careful review of the use of WPI, which does not include services, as the price index for arriving at current/constant price estimates of GDP/GVA.”

In other words, taking estimates of production at current prices and then using the deflator to compute the constant price estimate will give you a misleading result, simply because WPI shouldn’t be used as the deflator in many sectors. A similar mistake is made when arriving at current price estimates from constant price estimates.

Indeed, as this column has pointed out, RBI is worried about growth. The central bank has, after a rate cut of 50 basis points, indicated that GDP growth will be higher by a mere 40 basis points in FY 2017. Also, RBI had made rate cuts of 75 basis points this year before last Tuesday’s cut and yet it has revised downwards GDP growth for FY 2016 from 7.8% in its April policy statement to 7.4% now. A basis point is one-hundredth of a percentage point.

The implication, says RBS senior economist Gaurav Kapur, is the central bank knows that growth is not as robust as the GDP numbers show, which is why it is confident that inflation will remain low.