Why inflation rarely feels right

Food has a weightage of over 39% in the consumption basket used to calculate retail inflation.   (Photo: Mint)
Food has a weightage of over 39% in the consumption basket used to calculate retail inflation. (Photo: Mint)

Summary

  • When inflation cools, prices can still rise—but at a slower pace
  • Retail inflation, or the rate of price rise of what we consume, fell to 5.66% in March 2023 from 6.44% in February. Yet, inflation feels much higher than 5-6% for many people

Mumbai: [ Scene 1] The flat was quiet. Mummy ji had finally gone back home. Pooja’s husband, Rahul, was accompanying Mummy ji. Pooja had taken the opportunity and worked late into the night and completed the first chapter of her PhD thesis. The quietness was interrupted when her phone started to ring.

“So, cooking done?" asked Mummy ji.

“I was thinking of Swiggying it," replied Pooja, knowing fully well how much ordering food irritated her mother-in-law.

“It’s unhealthy beta," replied Mummy ji rather lovingly. “And look at all the weight that Rahul has put on."

“That he has," replied Pooja.

“So, I had called to ask a question actually."

“What question?" asked Pooja.

“You know Rahul’s father was reading the newspaper in the morning today and was saying that all this talk about inflation falling was nonsense."

“Hmmm."

“If inflation is falling, why are prices not falling? They seem to be going up even more."

“Interesting question Mummy ji," replied Pooja. “Who would have thought that a day would come when we would be discussing something other than our common love, Rahul."

Before Mummy ji could reply, Pooja asked: “What do you think happens when inflation goes up?"

“Prices go up," replied Mummy ji.

“And what do you think happens when inflation falls?"

“Prices go down."

“No," replied Pooja.

“No?" asked Mummy ji.

At that very moment, the doorbell to Mummy ji’s flat rang. The maid had come and now, Mummy ji had to supervise her.

[Scene 2] Around 90 minutes later. The conversation continues.

“So, I was saying that when inflation falls, prices should fall," said Mummy ji.

“No, that’s wrong," replied Pooja.

“Why?"

“Inflation is the rate of price rise over a period of one year. So, let’s say tomato is selling at 30 per kg currently."

“What a relief you know," interrupted Mummy ji. “I hate it when tomato crosses 50 per kg. Rahul’s Papa refuses to buy then."

“Let’s assume that one year from now, in April 2024, tomatoes sell at 40 per kg. What’s the rate of price rise?" asked Pooja.

“The rise in price is 10 per kg from an April 2023 price of 30 per kg. So, the rise is 33%."

“Right," said Pooja. “Now, let’s say in April 2025 tomatoes sell at 50 per kg."

“Hmmm."

“So, what’s the rise in the price of tomato from April 2024 to April 2025?"

“The April 2024 price has been assumed at 40 per kg and the April 2025 price has been assumed at 50 per kg. So, the price rise is 25%."

“Now, as I mentioned earlier, inflation is the rate of price rise. The inflation in tomato prices is 33% between April 2023 and April 2024 and 25% between April 2024 and April 2025."

“Oh, I now get it," said Mummy ji. “When inflation falls, prices rise at a slower pace. So, that does not mean that prices are not going up. They are still going up."

“Yes, Mummy ji," replied Pooja, happy to have been able to explain this rather simple concept which confuses so many people, to her mother-in-law. Nonetheless, she was curious and her curiosity led her to ask: “But tell me something, why did you ask this question?"

“Oh, that was because I knew that falling inflation does not mean falling prices," Mummy ji replied. “I studied economics in college."

“So, then?" asked Pooja.

“Well, Rahul’s Papa said that if inflation is falling why are prices not falling with so much confidence that it made me doubt what I already knew," she replied. “I mean I studied economics nearly four decades back."

The honesty of the answer almost brought tears into Pooja’s eyes. “Next time you have any doubts, please call," Pooja told Mummy ji. “It’s better that we talk economics than Rahul."

[Scene 3] Sometime in the afternoon on the same day. Pooja has just woken up from an afternoon nap and is brewing her favourite black coffee. The phone rings. Her friend Anjali is calling. Anjali is Pooja’s best friend from school, who is currently stuck in a soulless job with a bank where she leads a team trying to sell yet another credit card to someone who does not need it.

“Hey Poo," said Anjali.

“Bol Anju," replied Pooja.

“How is my hottie?" asked Anjali, referring to Rahul.

“Oh, the hottie’s mother is rather worried about his ever-growing paunch."

“You know, the paunch makes him look hotter Poo."

“Well," said Pooja. “Tell me why did you call."

“I wanted to understand something," she said. “I was going through an edition of Mint published earlier this month and saw that the retail inflation in March had fallen to 5.66% from 6.44% in February."

“Hmmm."

“My question is why does inflation feel much higher than 5-6%?" she asked.

“What is inflation?" asked Pooja, turning the question around.

“It is the rate of price rise," replied Anjali, who had studied some basic economics in a business school.

“The price rise of what?"

“Of what we consume."

“And what you consume is different from what I consume and what others consume."

“Yes," replied Anjali. “So?"

“Inflation, as reported by the government, is a theoretical construct. It’s an idea."

“Hmmm."

“In the real world, all of us have our rates of inflation given that we consume different kinds of things," explained Pooja.

“That’s true."

“Now, the government needs to calculate inflation at a societal level. When we say that retail inflation in March was at 5.66%, this is retail inflation for all of India."

“Yes."

“So, how does the government measure it?" asked Pooja.

“Honestly, I don’t know," replied Anjali. “But if I were to ever write a dystopian science fiction novel…"

“There we go…"

“Basically, all money will be digital. There will be no cash in my imaginary world. And there will be a central database which will maintain all the records of money being spent by all the people on the planet. As soon as the month ends, programs would run on this database and an inflation number for the month gone by would be cranked up."

“Well."

“And given that the database will capture every economic transaction, we will end up with the right rate of inflation."

“That’s really some idea."

“It is," said Anjali. “Which is why it is just in my head and not out there in the open."

It is exactly at this point that Anjali remembered that she had to be a part of a meeting where they would decide when to have the next meeting. “Call you back babes!" she said and ended the call.

[Scene 4] In five minutes, Pooja’s phone is ringing again. Anjali’s calling.

“Oh, the boss got called out to another meeting by his boss," Anjali said. “Frustration will soon boil down the hierarchy."

“Well."

“So, we were talking about the societal level of inflation."

“Yes. The government needs to calculate the societal level of inflation. In order to do that, it has to limit the problem of calculating inflation," said Pooja. “It can’t operate like the government in your science fiction novel, at least not at the moment."

“And how does it limit the problem?" asked Anjali.

“It creates a consumption basket of goods and services to serve as an index. Each good or service is given a certain weight. The price of these goods and services are tracked over a period of time across the length and breadth of the country. Inflation is calculated using this data," explained Pooja.

“Can you explain through an example?"

“Let’s assume a simple world in which there are two items, rice and dal. Both have 50% weightage in the consumption basket. Let’s say the price of rice from one year to another goes up from 60 per kg to 66 per kg. This implies an inflation of 10%. Rice has a weightage of 50% in the consumption basket. And 50% of 10% works out to 5%."

“Okay."

“Now let’s say the price of dal goes up from 150 per kg to 180 per kg. This is a rise of 20%. Dal has a weightage of 50% in the consumption basket. And 50% of 20% works out to 10%."

“Yes."

“So, the rate of inflation in this simple world is 5% plus 10%, which works out to 15%."

“That seems rather straightforward," said Anjali.

“The underlying principle is simple but there are hundreds of items that make up the consumption basket used to measure retail inflation," explained Pooja.

“So, now that you have got me interested in this, how are the weights of different items decided on?" asked Anjali.

“These weights are based on detailed consumption surveys carried out by government agencies, though one hasn’t been carried out for many years. You could say that the basket that has been constructed to measure inflation consists of goods and services in the same proportion as an average Indian consumes them."

“Very interesting."

“So, food has a weightage of a little over 39% in the consumption basket used to calculate retail inflation."

“Isn’t that huge?" interrupted Anjali. “This means that for every 100 spent, 39 goes towards food."

“Well, you seem to have forgotten that we are talking about the consumption basket of an average Indian and not of a fancy banker like you."

“Please no sarci babe!"

“As an individual earns more, the spending towards food as a proportion of total income comes down. In your case, it would probably be less than 5% of the money you make in a month. And this explains why the rate of inflation as calculated by the government doesn’t seem right to you. Your consumption weightages are totally different from that of an average Indian."

“Can you explain in a little more detail?"

“Take the case of your son. What proportion of your salary do you think goes in taking care of him? Everything from his school fees to his guitar classes to his swimming classes to his football coaching and so on."

“At least 10%," replied Anjali.

“Now, in the government consumption basket, education, stationery, etc., has a weightage of around 4.5%. In March, the price rise of items that come under this heading stood at 5.4%. In your case, the weightage is higher. This is because your son goes to an international school. Hence, the increase in his annual school fee would have been higher. He also does a lot of extra-curricular stuff."

“Makes sense," said Anjali. “Thanks for explaining this to me."

[Scene 5] Around 7pm the same day. Rahul has come back from his home town. He has just made Pooja’s favourite coffee and is beaming with a smile.

“So, what’s with the smile?" asked Pooja.

“Can’t a man just be happy to be back home?" replied Rahul. “I was missing you."

“Nah, this isn’t your missing me kind of smile," replied Pooja. “In that case, your eyebrows twitch in a certain way."

“Basically, I am happy that our home loan EMI hasn’t gone up," he replied honestly.

“Hmmm."

“Ashish has been scaring me. He had told me that the Reserve Bank of India (RBI) will raise rates in early April and that will lead to our bank increasing the home loan interest rates."

“Oh, the RBI did not raise interest rates this time around," said Pooja.

“But tell me something… why does the RBI raise interest rates?"

“The RBI raises rates in order to discourage individuals from borrowing and spending money. At higher rates, companies are also reluctant to borrow and spend more. In this scenario, lesser money chases goods and services and that helps in controlling the rate of inflation," Pooja explained.

“Makes sense," said Rahul. “You know, I am tired and I don’t feel like cooking, let’s Swiggy it."

Before Pooja could tell him that she felt like having Chinese, specifically, Kolkata Chilly Chicken and Chicken Fried Rice, her soul food, Rahul’s phone started to ring. Mummy ji was calling.

“Beta, what’s for dinner?" she asked, as soon as Rahul picked up the call.

(The example is hypothetical.)

Vivek Kaul is the author of Bad Money.

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