“Inflation that was thought to be transitory was, in fact, not that as the Fed and RBI realized, in what some would say too late a time.” A headline like this pops up on your TV screen every other day in a bold red band placed at the bottom, as you wonder what it means and how it affects you. Then, what is inflation, and what is going on now with prices in India?
Inflation Station: Breaking down the word
Imagine that your monthly expenditure on food was Rs 1000 per month in 2021. The following year, it became Rs 1100 per month for the same amount of food as the previous year. The purchasing power of money has declined since the same Rs 1000 per month will now buy you lesser food in 2022. This situation is called inflation and it refers to the rise in prices in the economy over time. It affects an individual because now they can buy lesser goods and services with the same money compared to the previous years, indicating that the individual must either increase their monthly expenditure to obtain the same amount of goods and services or cut down on some of them to retain their budget as was. Central banks typically set inflation targets so that it remains under control and the economy does not see a hike in rates or a period of recession owing to a low rate of growth. It is called inflation targeting and is controlled using monetary policy drivers like open market operations and interest rates. For purposes of measurement of inflation in India, two indices are used- CPI and WPI. WPI (Wholesale Price Index) refers to the inflation measurement across 697 categories of goods at the prices at which consumers buy them at wholesale rates. CPI (Consumer Price Index) is retail inflation which is analyzed through inflation measurement relating to goods and services across 260 categories. It takes into consideration prices paid by the consumer at retail prices.
Surge Verge: The recent data
After the Covid Pandemic, prices started surging as inflation rates grew. However, for the longest time, this inflation was assumed to be transitory inflation, a type of inflation that was read out of books but not experienced in the larger economical sense until now. Transitory inflation refers to high inflation periods that are thought to be temporary and do not become part of a long-term trend. Owing to the increase in fuel prices after the Ukraine-Russia tension situation and the emergence of economies from the pandemic leading to increased expenditure on food, the inflation rates rose. Average contributions to inflation by food alone had exceeded the overall average rate of inflation between 2016-2020. As Central Banks waited all across the world for inflation to ease, Jerome Powell, the Chair of the Federal Reserve of the United States retired the use of the terminology “Transitory Inflation” in Nov 2021 meaning that it was declared to be persistent inflation. Policymakers then shifted gears from supporting growth to pulling up interest rates. While there has been some indication of peaking inflation which means stabilization of prices, however, it is still not broad-based (which is a euphemism for inflation effects being felt everywhere). Thus, while inflation is driven by global factors, Central Banks of governments play a fundamental role in controlling inflation rates. The latest numbers report a CPI drop to a 1-year low of 5.72% in Dec. 2022 from 5.88% in Nov. 2022
Headline Vs Core: The way forward
In its mandate, the Reserve Bank of India includes only headline inflation for measurement and analysis which is the inflation of goods and services including energy and food. On the other hand, core inflation refers to retail inflation excluding energy and food. It has been a general observation that core inflation is generally higher than headline inflation. It is more sticky and less volatile. Headline inflation is influenced by transitory drivers as well as persistent ones. While food and energy are the transitory drivers that depend on supply shocks and farm yield periods of monsoon, persistent drivers are ones that are driven by aggregate demand and are more amenable to monetary policy actions. Since core inflation removes such volatile price changes and shows us the underlying inflation rates, it helps to frame monetary policy in that deliberate manner as it operates with variable lags. However, with the inflation anchor largely depending on headline inflation and core inflation not being used for external communication with the public, when inflation rises and the government does not partake in monetary policy changes, it leads to unrest. Hence, several studies have been conducted on the ways core inflation can be included in government mandates for proper inflation anchoring.
CPI Vs WPI: The better half
This has been a debate for the books as it still hasn't been nipped in the bud. The relative importance and use of CPI and WPI are still not properly agreed upon. There is of course, the structural discrepancy in both the measure which leads to changes, for instance, CPI does not face the effects of the rise in crude oil prices while WPI does not take into account the service prices. WPI in India has been considerably higher than CPI for some time now. Let us understand this with an example. The rise in the charge of shipping prices leads to an almost immediate rise in the price of imported goods with 90% of the increase transmitted down the supply chain within two months. After two months, the shipping-cost shock is reflected in local producer prices and thus, is reflected in WPI. Consumer prices, on the other hand, rise more gradually reflecting transmission through the domestic supply chain by importers, producers, intermediaries, and, eventually, retailers which then reflects in CPI.