D Subbarao said central banks tend to articulate the price stability objective in terms of CPI, considered a better indicator of the cost of living and, hence, reflecting the welfare objective of monetary policy
The Reserve Bank of India (RBI) said on Friday the huge difference between the Wholesale Price Index (WPI) and Consumer Price Index (CPI) was coming in the way of properly assessing inflation.
"To some extent, the divergence between WPI and CPI can be attributed to statistical differences stemming from coverage, classification of items and the relative weights of their constituents. However, there could be other reasons for this as well. For example, higher transaction costs, taxes, etc., are reflected in the CPI but not in the WPI. Regardless of the reasons, the large magnitude of the short-term divergence between the two indices poses a major challenge for assessing inflation dynamics in the short-term," said RBI Governor D Subbarao in Mumbai. The WPI-based inflation rose in July to 5.79 per cent, a four-month high. However, CPI-based inflation declined to 9.64 per cent in the month from 9.87 per cent in June. Subbarao said central banks tend to articulate the price stability objective in terms of CPI, which is considered a better indicator of the cost of living and, hence, reflecting the welfare objective of monetary policy.
On what should be the preferred measure for calibrating monetary policy in the Indian context, he said: "The traditional practice in RBI has been to use WPI as the headline measure of inflation. The primary reason for this is that the legacy CPIs were not representative enough for the entire population... In India, WPI has been more extensively researched by way of its empirical relationship with other relevant variables such as output, monetary aggregates and interest rates, therefore, presents richer analytical insights. Though that even as we use WPI as the headline measure of inflation, we also study the trends in CPI-based inflation and the findings of household inflation expectation surveys for calibrating our monetary policy."
Subbarao said WPI would never be abandoned even if the move is made to CPI. "Analytically, it (WPI) would be useful to develop a series of producer price indices that would help us to gauge how price momentum builds up in the economy," said Subbarao.
He said the new CPI-based inflation series has 19 data points, which are not sufficiently long for statistically robust analysis. Plus, in the new CPI, food prices comprise 50 per cent of the index, making the movement of CPI relatively more sensitive to food price changes.
"This implies that the influence of supply-side factors could dominate the trends in CPI. Also, house rents comprise about 10 per cent weight in the new CPI. With house rents being largely imputed, there could be concerns about the efficacy of their measurement. These issues are not unique to us. Several central banks emphasise monitoring CPI-based inflation, excluding housing, food and energy, but in our case similar exclusion would leave the CPI bereft of substantial coverage and information content," said Subbarao.
Subbarao was speaking about some of the dilemmas RBI faces in making policy because of the constraints of data. According to him, the threshold level of inflation is defined as the rate of inflation beyond which inflation itself becomes a drag on growth. "Estimating threshold inflation is no less daunting than estimating potential output. Like potential output, threshold inflation is also unobserved and is time-varying. Its estimates are, therefore, model dependent with the associated potential for errors," he noted.
According to him, the challenge of preserving and bolstering financial stability has taken centre stage after the crisis. "By far, the biggest challenge both for policy makers and statisticians is that there is as yet no universally acceptable definition of financial stability. Financial stability is also multi-dimensional, encompassing as it does, economies, markets, the financial sector institutions and financial market infrastructure, and hence is more difficult to measure." He added considerable research efforts should be devoted to the development of indicators for financial stability analysis, which must be employed for comprehensive assessment of the risks to the stability of the economy and the financial system.