Is WPI a better measure of Inflation than CPI?

Abstract

Although traditionally, Inflation has never been a major cause of concern for the Indian policy makers but things have changed quite a bit in the recent few years. Keeping a check on it and keeping it in a comfortable range is now a very important part of any country’s Monetary policy. This calls for proper estimation of the price rise that reflects the situation of the majority of the population and thus focusing on the right Inflation index is extremely important. This becomes quite a challenge considering the fact that it is an uphill challenge to construct a single or maybe focus on a variety of indices that give proper direction to any Inflation policy. This paper attempts to review the major inflation indices constructed in India, study the ones that are majorly considered, analyze their major benefits and shortcomings and see if the WPI index is really superior to the CPI Index. We will also see which are the ones that are majorly used in some of the developed nations like US, UK and Italy.

The Whole-sale Price Index

The WPI Index measures the change in the commodity prices at the level of the wholesalers or producers, i.e. at the early stages of the distribution system. WPI has the broadest coverage (in terms of the number of factors and commodities that it covers) as compared to all other indices. It the only index that keeps a track of the deviations of all the traded goods on a weekly basis and thus is extensively used and considered in developing countries like India. It has been so widely used that important monetary and fiscal decisions and policies being related to it have been the rule rather than the exception in recent years.

Headline WPI Inflation usually considers all the goods and commodity prices while the Core WPI Inflation excludes the most volatile (perhaps the most important also) commodities like fuel and food, which downgrades its authenticity.

Composition of WPI

Manufactured goods occupy the heaviest weight in the composition of the WPI index and have a weight of around 65% (which includes food items, non food items and Minerals), primary articles are the next in line and have about 20.1% of the weight, and Fuel and Power have about 14.9% of the composition.

Limitations and Problems with WPI

The following points list down some of the major limitations and criticisms of this index:

• One of the major criticisms of the WPI index comes from the fact that it does not include and account for services in its measurement. Although it is also known that once this index accounts for the services, it will look more or less like the national income deflator.
• It has also been accused of being static rather than dynamic in nature as the different weights associated in the measure have not undergone major changes, this is of some concern especially when accounting for economies like India that are undergoing major structural changes.Availability of quality data on a continuous basis is also a problem especially in the services sector (and within the services it is the non-tradable services) and because of the fact that this measure accounts for so many commodities and goods, the collection of such holistic data on such a frequent basis is costly and thus a problem.
• Another limitation of this measure is the fact that it only measures the value of gross transactions in the economy, and the fact that it neither pays any heed to the producer’s or the consumer’s basket for the measurement of Inflation.Given the fact that the calculation of this index normally uses the Laspeyre’s formula, this accounts for the need of continuous base year revisions in its calculation, particularly in an economy that is subjected to continuous significant structural changes and that too, at a rapid rate.
• Exclusion of services in its calculation is a major source of distortion in a country like India, and also, the price relatives that are based on gross transactions rather than being based on the price of final goods, have a distorting impact on the calculation of the relative weights in the calculation of the Index.

A 1996 Commission final report titled, ‘Towards a more accurate measure of the cost of living.’ highlights the most basic limitations faced by the methodology of using fixed weights in measures like WPI: [1]

• Substitution bias stems from the fact that the fixed market basket that is considered fails to take into regard the fact that the consumers can easily substitute for the more expensive goods with the relatively cheaper goods when the relative price of the good changes.
• Outlet substitution bias also takes place when the gradual shifts to the lower price category outlets are not properly accounted for.
• When the improvements in the quality of products are not properly measured or if they are not measured at all, then the problem of Quality change bias also pops in.
• And if the new products that are introduced in the marketplace are not introduced in the market basket, then there is always the problem of New Product bias.

Consumer Price Index (CPI)

The consumer price index measures the change in goods and services at the consumer level. The recent literature on Inflation targeting is of the view that targeting the headline CPI is more welfare improving than core CPI .( Catao and Chany 2010). Earlier, India was composed of 4 CPI Indices, namely, CPI industrial workers, CPI- Rural laborers, CPI- Agricultural laborers and CPI-Urban non manual employees.

A new CPI index was launched in Jan 2011 with base year of 2010, that is aimed at measuring the change in prices of goods and services that are consumed by the rural and the urban population, it is now being extensively regarded for policy purposes.

Composition of CPI

The largest contributor in the composition of CPI is given to the category of food , beverages and tobacco which is given a weight of 34% (which includes cereals, pulses , protein items, fruits, vegetables etc.), next in line is the category of Housing which includes Rents, repairs etc. and is given a weight of 27%. Fuel and lightning is given a weight of 8% and it includes goods like kerosene, LPG, electricity etc. This measure also includes the items of clothing, bedding and footwear and assigns them a weight of 3%. The rest of 28% is assigned to miscellaneous items like medical care, education, amusement and entertainment, transportation, personal care etc.

CPI vis-à-vis WPI

There is generally a 2%-3% difference in the WPI and CPI inflation indices with CPI usually being higher. This difference generally stems from the fact that both of them have different base years and from the fact that their commodity compositions and the relative weights assigned are pretty different, and thus the difference. In the Indian scenario, the base year for the WPI Index is taken to be 2004-05 while the base year for CPI is taken to be 2010.[2]

A major reason for the fact that CPI generally outmatches the WPI index is the fact that food has a bigger contribution in terms of weight in the calculation of the CPI Index and in the recent past India has been witnessing higher food inflation. The Labor Bureau of India holds authority for the calculation of CPI-Industrial workers which basically attempts to account for the changes in the retail prices of the goods and services being consumed by the target groups. Its coverage is regarded to be higher than CPI-AL and CPI-UNME.

Limitations and Problems with CPI

• As is generally inevitable, statistical errors do occur when compiling the CPI or indeed any sort of a price index, because what we are actually doing is we are only analysing a sample of goods and services in a whole universe of transactions in the economy. However, the entire framework can be made reliable and accurate if robust methodologies are put in place.
• The CPI index aims at providing just an effective representation of the corresponding price changes in the economy. The issue of miscalculation or bias may arise when the choice of the commodities or the weights assigned run the risk of becoming obsolete or unrepresentative over time, and thus calculation bias may very well occur.
• There are generally five sources of ‘bias’ in the measurement of CPI, namely:
• Item substitution
• Outlet substitution
• New goods not being priced
• New outlets not being priced
• Quality change
• Prices of different products do rise at different rates. As specific goods in the economy becomes more expensive relative to others, consumers do tend to shift towards the cheaper goods and thus change their microeconomic preferences. Now, because the CPI uses a fixed basket of goods and services and assigns fixed weights to them, it will assume people stick to the same preferences and bundles of goods as they were consuming previously before the change in price. However, in reality, they are buying less of the relatively expensive products. So their overall expenses may very well be not as large as the CPI suggests.
• The CPI index does face a problem in accounting for the change in the quality of the products. There is invariably an increase in the quality of the goods being produced in the economy with the rise in technology and better production techniques. However, since the index assigns calculations on only a fixed basket of goods, an inherent assumption is that the product quality does not change.

Thus any change in prices of the goods is assigned to Inflation without taking the fact of the increase in product quality into regard.

Inflation in India

As our former RBI Governor famously quoted in 2010 that our headline Inflation index is the WPI index, which unfortunately, by definition does not reflect the consumer price situation. This is a major drawback in itself and a continuous cause of concern for the policy makers. The basic notion behind the superiority of WPI over CPI in India is given by the following reasons:[3]

• Since in India, WPI, unlike CPI is available on a nationwide basis and is provided on a weekly basis, it becomes a much better candidate for considering and using it for the policy purposes.
• WPI is the index which is available on a minimum possible time lag of two weeks. It considers a total of 676 commodities on a price level and tracks them, which is an indicator in the price movements of all the goods and commodities.

On the other hand, the Consumer Price index in India considers multiple series based on different sections of the society.

There are basically four categories of CPI that are calculated.

1. CPI-UNME (Urban Non Manual Employee)
2. CPI-AL (Agricultural Laborers)
3. CPI-RL (Rural Laborers)
4. CPI-IW (Industrial workers)

The CPI-UNME is published by the Central Statistic Organization while all the others are calculated by the Department of Labor. However, from February 2011, the CPI-UNME has been replaced by the CPI-urban, CPI-rural and CPI-combined.

In India, Inflation has been in the comfort zone of around 5% or less, in almost every year since 1998/9, actually Inflation has been subdued since 1996/7 [4] Even in the wake of the sub-prime crisis in 2007/8 and despite the global commodity price shock, inflation remained relatively stable and was reflected in the GDP deflator in the range of only 4.1%. Thus Inflation was never really a major macroeconomic concern for the policy makers until the year of 2008, however things really changed after that, and the situation turned sharply adverse. And thus, today controlling Inflation is right on top of the priority list of Monetary Policy objectives in the country.

Some of the data to suggest the inflation trend in India is given below: [5]

Base Year

• Most of the indices for the most widely used measure i.e. WPI are fairly outdated, the most recent weights among these are from CPI-IW which are actually based on an ad hoc survey carried on by the NSSO on the expenditure patterns in India in 2001, rest of the others are fairly outdated.
• Right up to August 2010, the WPI had 1993-94 as its base period, which is fairly outdated; it was only in this month that the new WPI was released with base year of 2004-05.

Exclusion of Services

• There is no specific index that takes services into account, neither at the consumer nor at the producer level. This is surprising considering the fact that services account for almost half of India’s GDP and are also a major component of any household’s expenditure. Thus a complete ignorance of services does not bear fruit for the credibility of the measured index.
• Only CPI-IW is one measure that accounts for some services in its measurement, but this is not routinely collected or easily available. And also, various services have not been properly collated into a single index; hence it is not really reliable as well.

Examples from other countries

United States of America

In US, the CPI is available for two population segments-

• CPI-U (urban customers) that covers about 87% of the population.
• CPI-W (wage earners and clerical workers) that covers about 32% of the population.

Only those goods that are included in the consumption baskets of the clerical workers or the workers with an hourly wage are included in the calculation of CPI-W. In addition to this, measures are also taken to contour the region to region variations in Inflation, especially with US being such a huge and diverse nation with huge region-wise variations in economy. However, the US Federal Reserve board tends to focus on personal consumption inflation deflator and CPI-U.

United Kingdom

In the UK also, the CPI index is the preferred one for macroeconomic analysis and policy-making. While the Treasury specifies the adequate inflation rate and which index to target, it is the duty of the UK Central Bank to adopt adequate policies to achieve that specific rate. In addition to this, there is also a general purpose indicator of Inflation which is given the name of the Retail Price Index (RPI) which is predominantly used for the indexation of pensions, benefits and much of the index-linked gilts that are issued by the UK government. A variant of the RPI is the RPI-X.

The producer price index (PPI) is a monthly sur­vey that measures the price changes of goods bought and sold by UK manufacturers. This index collects information and helps develop the factory-gate prices or the so called output-priced index, which measures the rise in prices of commodities sold by the producers and manufacturers.

There is also the services producer price index (SPPI) which is a quarterly survey of prices charged for services provided by the firms and businesses in UK to the other firms and government in the UK.

Thus multiple price measures play an important role in macroeconomic policy making and are more of a necessity rather than anything else, mainly because there are many other large and diverse and heterogeneous countries like India.

Italy

There are three in­dices for consumer prices in Italy-

• CPI for the whole nation (NIC) which is based on the household consumption expenditure patterns of all the households in the economy.
• CPI for the blue and white collar households.
• Harmonized index of consumer prices (HICP), which is prepared according to the European Union regulations and norms that are in place.

While the underlying process for the collection of data for these indices is primarily the same, the entire difference lies in the assigning of different weights and priorities in these indices and the section of the society that they focus on.

Below is a table used for different indicators used in a list of selected economies:-

By: Ansh Gandhi

References:

[1] WPI evolution of the weighting diagrams index

Click to access WPI%20Evolution%20of%20the%20Weighting%20Diagrams.pdf

[2] Inflation Indices – IDFC

Click to access Inflation-Indices.pdf

[3] How Should Inflation Be Measured in India? by Ila Patnaik, Ajay Shah and Giovani Veronese

Click to access how-to-measure-inflation-in-india.pdf

[4] Shankar Acharya, Macroeconomic performance and policies 2000-2008.

Click to access workingpaper225.pdf

[5] Shankar Acharya, Macroeconomic performance and policies 2000-2008.

Click to access workingpaper225.pdf