What is the GDP deflator and why is it in the news now?
The GDP deflator, also called implicit price deflator, is a measure of inflation. Simply put, it is the ratio of the value of goods and services an economy produces in a particular year at current prices to that at prices prevailing during any other reference (base) year. This ratio basically shows to what extent an increase in GDP or gross value added (GVA) in an economy has happened on account of higher prices, rather than increased output. Since the deflator covers the entire range of goods and services produced in the economy — as against the limited commodity baskets for the wholesale or consumer price indices — it is seen as a more comprehensive measure of inflation.
The deflator is in the news because Chief Economic Adviser Arvind Subramanian has referred to it to show that inflation currently is at very low levels. Annual inflation based on the GDP deflator was 1.66 per cent during April-June and 0.21 per cent in the preceding quarter. It was even lower based on the GVA deflator: 0.07 per cent in April-June, and minus 0.13 per cent in January-March. (GVA is essentially GDP net of all product taxes and subsidies; the GVA deflator, hence, yields a truer picture of the underlying inflation in the economy.) According to Subramanian, the near-flat GDP/GVA deflators indicate that “we are closer to deflation territory and far, far away from inflation territory”.
How does this tally with the inflation rates based on the more commonly-known wholesale price index (WPI) and consumer price index (CPI)?
WPI inflation is already in negative territory for the last nine consecutive months since November. It averaged 0.33 per cent in October-December, minus 1.82 per cent in January-March and minus 2.35 per cent in the April-June quarter. On the other hand, CPI inflation — which the Reserve Bank of India (RBI) employs as the “nominal anchor” for its monetary policy operations — has been much higher, averaging 5.27 per cent in January-March and 5.09 per cent in April-June. The accompanying chart shows that the deflator-based inflation has tended to be higher than WPI inflation and lower than CPI inflation, but closer to the former than the latter.
Of the three, which is the most reliable measure?
As already mentioned, the deflator is the most accurate indicator of the underlying inflationary tendency, as it covers all goods and services produced in the economy. The other two indices derive from price quotations for select commodity baskets. The WPI basket includes 676 commodities; all of these are only goods and whose prices are captured at the wholesale/producer level. The CPI considers inflation at the retail end, while also including services.
But since only goods and services directly consumed by households — from foodstuffs, clothing and petrol to health, education and recreation services — are taken, the CPI does not tell us what is happening to prices of cement, steel, polyester yarn or compressors. While retail inflation is, no doubt, important, policymakers cannot ignore the prices that producers — both of consumer as well as various intermediate and capital goods — are receiving. Prolonged negative WPI inflation could, indeed, be indicative of deflationary pressures not being adequately reflected in the CPI. Given all these, the deflator is a better gauge of inflation (or even deflation, as Subramanian is suggesting) in the economy.
So, why is the deflator not much in use?
The main reason is that it is available only on a quarterly basis along with GDP estimates, whereas CPI and WPI data are released every month.
Why is the RBI stuck on CPI inflation when both the deflator and WPI inflation rates point to the possibility of the Indian economy being in deflation mode?
The RBI’s basic logic for targeting CPI inflation is simple. The inflation thatconsumers experience or expect in future is what gets factored in wage bargains and also determines the allocation of household savings across different assets. The job of monetary policy is to see that the public’s inflation expectations are firmly anchored, so as to prevent any wage-price spirals. Interest rates will also have to be sufficiently above CPI inflation, so that households continue to park their savings in bank deposits as opposed to gold or real estate.
But the criticism of this approach is that it works in normal times, whereas today we have an abnormal situation of deflation — at least from the producers’ end. Given zero, if not negative, WPI or deflator inflation and 10 per cent-plus nominal borrowing rates, firms are effectively paying double-digit real interest rates. This is as unsustainable a situation as the negative real interest rates that savers were getting, not too long ago, on fixed deposits. That being the case, the benefits to producers from a sharp cut in interest rates may far out outweigh losses to savers. Also, savings ultimately come from incomes, which, in turn, are a function of growth and jobs in the economy. Monetary policy will probably have to reconcile itself to this reality. The RBI was behind the curve when inflation took off in 2011-12; it cannot afford to be behind the curve on deflation today.