Understanding Inflation

CONCEPT – INFLATION

Inflation is the rise in level of prices.
Higher inflation rate is higher rate of rise in prices.
Lower inflation is lower rate of rises in prices, but prices rise (do not fall).
Negative inflation is the fall in level of absolute prices.
Inflation rate can be defined in multiple ways, based on our needs.

Measuring inflation in India : To do this, the Wholesale Price Index (WPI) and Consumer Price Index (CPI) are used. The WPI helps in measuring the average change in prices received on bulk sale of goods. The Consumer Price Index measures changes in the general price level of a class of consumer goods. The RBI uses CPI for its Monetary Policy.
Wholesale Price Index (WPI) : It estimates inflation by ascertaining the price paid on the purchase of goods by the wholesalers from manufacturers and comparing it with the base year prices. A fixed basket of commodities is used.
Major Differences between WPI and CPI :

Wholesale Price Index (WPI) estimates inflation by ascertaining the price paid on the purchase of goods by the wholesalers from manufacturers and comparing it with the base year prices.
In India, Wholesale Price Index is published by Office of Economic Advisor under the Ministry of Commerce and Industry. The Consumer Price Index is declared by Central Statistics Office (CSO), under the Ministry of Statistics and Programme Implementation (MoSPI).
In wholesale Price Index, the inflation is measured by tracking the price paid at the first stage of the transaction. But the price paid at the last stage of the transaction is used to measure inflation in consumer price index.
WPI basket covers the only price of goods, whereas services like housing education, recreation and so forth are also covered in CPI basket along with the goods.
WPI deals with the prices paid on the trade of goods between two business houses for the purpose of resale. But CPI deals with the prices of goods bought by the consumers for the purpose of consumption.

Indexation : This is the process of adjusting the monetary proceeds such as wages, interests, dividend, taxes, etc., with the help of a price index, so as to compensate for changes in general price level and maintain the buying power of the consumers.

WPI versus CPI

RBI – Flexible Inflation Targetting Framework (FIT)

Step 1 : The Expert Committee to Revise and Strengthen the Monetary Policy Framework Report (January 2014) started the process on FIT. This was called the Urjit Patel Committee.
Step 2 : The subsequent Agreement on Monetary Policy Framework by Government of India and RBI on February 20, 2015 laid the path.
Step 3 : The amendment of the Reserve Bank of India Act in May 2016 paved the way for the adoption of flexible inflation targeting framework for monetary policy and the constitution of a Monetary Policy Committee.

RBI – FIT – Six Principles of Flexible Inflation Targeting

ONE : The primary role of monetary policy is to provide a nominal anchor (i.e. low, stable long-run inflation expectations) for the economy; the weights given to any other objective must be consistent with this.
TWO : Effective inflation-targeting has beneficial first-order effects on welfare by reducing uncertainty, anchoring inflation expectations and reducing the incidence and severity of boom-bust cycles.
THREE : Fiscal and other government policies may make the task of monetary policy easier and more credible, or more difficult and less credible.
FOUR : Because of lags in the monetary transmission mechanism, and concern for deviations of output from potential, as well as of inflation from the long-run target, following shocks it is not desirable to aim at keeping inflation exactly on target.
FIVE : In view of possible short-run trade-offs between the inflation targets and other objectives, the conduct of monetary policy must have sufficient independence from the political process to achieve the announced objectives.
SIX : Effective monitoring and accountability mechanisms are required to ensure that central banks behave in a manner consistent with announced objectives and sound practice.

RBI – FIT – In action

RBI’s flexible inflation-targeting (FIT) framework :
(a) The headline CPI inflation measure is being used as the target rate of inflation as it reflects the prices of essential consumption goods.
(b) Inflation in these prices hurts people in lower-income groups more as they spend a higher proportion of their incomes on these items.
(c) Since the objective of monetary policy is to maintain price stability so as to protect ordinary citizens from shocks of inflation, targeting headline inflation is the appropriate choice.
What is the headline inflation? It measures the overall inflation in the economy. The core inflation measure removes the prices of highly volatile food and fuel components to kill temporary effects.
Supply shocks in India : The inflation process in India is affected by supply shocks like rainfall, oil price shocks etc.). The headline CPI inflation in India tends to increase whenever there is a surge in food and fuel prices.
Monetary Policy’s impact : It affects output and inflation with a lag. Hence, the impact of monetary policy action today in response to a supply shock would materialize only some quarters later. Conversely, core inflation excludes the highly volatile food and fuel components and therefore represents the underlying trend inflation. Even when food and fuel inflation moderates over time, persistently high inflation in non-food, non-fuel components poses an upward risk to overall future inflation.
Why is core inflation so important? It represents the underlying inflation trend, and high core inflation today carries the seeds of high future inflation. Headline inflation will revert to core inflation sooner or later.