One vital decision for central bankers is which single price index (and corresponding measure of inflation) they should focus on. The phrase “focus on” is used instead of the word “target”, since focusing on a certain measure does not imply that it is being mechanically targeted.
Across the world, central banks choose the consumer price index. Their primary task is to preserve the domestic value of the currency. It is the legal, and in some sense moral, responsibility of the central bank to ensure to the public that the contracts they enter into are protected against changes in the aggregate price level. It is the CPI that enters into wage and financial contracts either via dearness allowance (DA) adjustment or other legal clauses, or via individual adjustments based on inflation expectations. The DA arrears that the Seventh Pay Commission will dole out at some point will be based on consumer prices. On these grounds, the CPI can also be called the
correct price index.
When the Urjit Patel Committee report recommending inflation targeting was released in January 2014, there was huge opposition to it.
One of its main recommendations was to base monetary policy solely on the CPI, and ignore the wholesale price index. This recommendation was criticised by many who argued that the RBI should stick to its traditional approach, which had served it well in the past, and mainly look at the WPI. It is beyond the scope of this article to critique the arguments in favour of the WPI made over the years, and that were also repeatedly made after the Urjit Patel report.
Last week, Chief Economic Advisor Arvind Subramanian (‘At the rate of?’, IE, June 12, iexp.in/jWB166509) raised the issue of CPI versus WPI because of their huge divergence, with negative WPI inflation at present. He calculated the different real rates of interest (the nominal repo rate minus inflation) corresponding to the various inflation measures. He ignores the GDP deflator due to recent problems with the reliability of GDP data.
He suggests that monetary policy should balance the interests of producers and consumers, and so an average of the WPI and CPI is desirable compared to just the CPI. The divergence between the CPI and WPI is unusually high at present, with a real rate of 2.4 per cent based on the CPI, and 5.9 per cent based on an average of the WPI and CPI. He also emphasised that balance sheets are stressed, bank non-performing assets are high and so financial conditions may warrant a lowering of the repo rate. Subramanian ends by asking whether the current policy stance is appropriate and states that there needs to be more analytical discussion.
To begin with, it should be clarified that, overall, I favour a “Taylor strategy” — the policy rate should respond to both the output gap (not try to boost growth per se) and inflation. But this should not be done using a strict formula such as the Taylor rule.
Instead, it should be done in a discretionary way. At any time, if the repo window is in sustained surplus mode, the RBI will have to ease no matter what the inflation rate is at that time. Similarly, extreme distress in systemically important financial institutions may warrant easing to avoid a potential financial meltdown. But whether the debt-heavy infrastructure and other companies in India now fall under this category is not that clear.
Unfortunately, most discussions about the CPI mix up two separate issues: the need for monetary policy to avoid being based on a strict rule and adopting the CPI as the official inflation measure. Indeed, the earlier misplaced emphasis of the RBI on the WPI was perhaps because it was used as a proxy for the output situation, having a much higher correlation with industrial production, as well as broad money and credit growth. But these considerations only imply that policy should directly take into account the output situation by explicitly following a Taylor strategy, rather than using the WPI in lieu of the CPI as its inflation measure.
The writer is professor, IIM Bangalore