India’s core inflation – a note

On March 19 2010, RBI increased interest rates before the official policy. The main reason was rise in inflation and inflationary expectations.

Anchoring inflation expectations and containing overall inflation  have become imperative.  Headline WPI inflation on a year-on-year  basis at 9.9 per cent in February 2010 has exceeded our baseline projection of 8.5 for end-March 2010 set out in the Third Quarter Review.

Year-on-year WPI non-food manufacturing products (weight: 52.2 per cent) inflation, which was negative (-0.4 per cent) in November 2009, turned marginally positive (0.7 per cent)  in December 2009 and  rose sharply thereafter to 2.8 per cent in January 2010 and further to 4.3 per cent  in February 2010. Year-on-year fuel price inflation also surged from (-)0.8 per cent  in November 2009 to 5.9 per cent in December 2009, to 6.9 per cent in January 2010 and further to 10.2  per cent in February 2010. With rising demand side pressures, there is risk that WPI inflation may cross double digits in March 2010.

Note the importance of non food manufacturing inflation.

Again in RBI’s monetary policy held in April 2010, RBI Governor Mr D. Subbarao said:

…….the developments on the inflation front are worrisome. The headline inflation, as measured by year-on-year variation in Wholesale Price Index (WPI), accelerated from 0.5 per cent in September 2009 to 9.9 per cent in March 2010, exceeding the Reserve Bank’s baseline projection of 8.5 per cent for March 2010 set out in the Third Quarter Review. Year-on-year WPI non-food manufactured products (weight: 52.2 per cent) inflation, which was (-) 0.4 per cent in November 2009, turned marginally positive to 0.7 per cent in December 2009 and rose sharply thereafter to 3.3 per cent in January 2010 and further to 4.7 per cent in March 2010……

Clearly, WPI inflation is no longer driven by supply side factors alone. The contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4 per cent in November 2009 rose sharply to 53.3 per cent by March 2010.

In both, RBI is talking about two measures of inflation. First is headline inflation and second is non-food manufacturing products inflation. Though India does not have separate categories, we could call the second one as core inflation. Ideally core inflation should also be based on CPI inflation but we don’t have a reliable CPI measure as of yet.

Let us understand these two measures a bit. Headline inflation includes all the items in the WPI index. Core inflation excludes certain items that face volatile price movements. Prices of certain items are highly volatile like food and fuel items. These prices provide confusing signals to policymakers. The prices of food and fuel items could increase sharply for few weeks and then decline sharply. This makes headline inflation also volatile. If policymakers increase interest rates seeing the rise in headline inflation, they could be surprised by a sudden lower trend in coming weeks. And monetary policy impacts economies with a lag, it complicates the policy further.

Hence, core inflation has emerged as an alternative for measuring inflation. In this, volatile items like food prices and fuel items are excluded. However, some economists criticize using core inflation as measure of inflation. As food and fuel are important items for consumption, they should not be excluded from the inflation measure. A focus on core inflation will miss the overall inflation trend. Suppose the prices of food and fuel increase for a prolonged period this will not show in core inflation but in headline inflation. So, should the policymakers ignore the headline inflation and focus on core inflation? Therefore, policymakers focus on both headline and core inflation for their policymaking. Most economies report both measures of inflation.

In India, we do not report core inflation and only headline inflation is reported. However, core inflation can be computed. WPI Inflation is divided into three broad categories

• Primary Articles
• Fuel Products and
• Manufacturing Items.

The first two categories include food articles and fuel items which can be excluded. The third category – Manufacturing also includes food products which tends to be volatile as well and moves in line with prices of primary articles. So after excluding food products from manufacturing sector, we get non-food manufactured products inflation. This can also be called as core inflation for India (not very reliable though). The weight of Manufactured Products in the total WPI index is 63.8% and food products is 11.5%. So core inflation has items which constitute about 52% of the total headline inflation.

The figure below shows movement of core inflation since Jan 2000. It peaked in August 2008 at 11.14% leading to multiple hikes at that time. The inflation then declined thereafter because of the global financial crisis. As RBI Governor states in his above mentioned statement, it was negative 0.4% in November 2009 and then increases sharply to 4.2% in February 2010. This prompted RBI to increase its policy rates before monetary policy. RBI again increased its policy rates in April 2010 seeing continued rise in core inflation.   

 It will be important to keep looking at this measure of inflation. Though not as robust, it does help in some way to understand demand-side inflation pressures in the economy. And this is what keeps central banks interested as well.