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Tuesday, June 28, 2022

The Thursday syndrome

Today is weekly inflation data day. Every week, courtesy bad number crunching, we are misled

Written by Ilapatnaik |
August 21, 2008 1:08:29 am

Today the weekly headline inflation figure will be released again. It’s becoming a Thursday syndrome — sharp increase in inflation in recent weeks shock and surprise both the government and observers of the Indian economy. Could this have been avoided, given that shock and surprise aren’t good inputs to policy-making? Yes. Early warnings of inflation were available in January 2008. But our method of inflation-watching is faulty.

We watch the year-on-year inflation rate based on the wholesale price index. There has been a debate about how the WPI is not revised on time, or on how the weights do not reflect the consumption or production basket. However, we are stuck with the WPI for now.

What does the rate measure? Standing in August 2008, an increase of 10 per cent year-on-year in the price of oil, for example, means that if, in August 2007, the price of oil was Rs 100 per kg, then today the price of oil is Rs 110 per kg. This could have been because the price rose from Rs 100 to Rs 150 in December 2007, and since then declined to Rs 100 in February 2008, and has stayed steady since March 2008.

Alternatively, it could be that the price of oil remained steady at Rs 100 per kg till March 2007 and has since been steadily rising, and is now up to Rs 110. The two scenarios say very different things about the inflation process. The first one suggests that there was a sharp spike in prices late last year, and we don’t need to take any anti-inflationary measures today. The second, however, suggests that we should worry as prices seem to be getting higher and higher.

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When we focus on inflation on a year-on-year basis, as we tend to do in India, we miss out on the inflationary process described above. Also, as the clamour and the drumbeats increase, policy could, erroneously, respond to price rise that has actually already been brought under control. Or, it could mean that when prices start moving on an upward path month after month, the year-on-year rate will miss the trend.

The way this problem has been addressed in developed countries is to focus on monthly changes. There is, however, one problem with monthly changes. If there is seasonality in the data, it might suggest there is a rise in prices and we might start taking policy action, but that would be a mistake. In other words, when the mango season ends — as is happening now — and the price of mangoes goes up, even doubles, or triples, there is no need to panic. This is merely seasonal. The price of mangoes will come down when the next mango season comes. So while economists like to focus on monthly inflation, they do so after seasonally adjusting the data. All this seems fairly obvious. Some of the simplest techniques available to do this are nearly a hundred years old. The latest techniques are ubiquitous today, software packages to apply them are available for free download on the internet and any economist with a training in statistics and with a view to understanding the process of inflation in India can do so with fairly little effort. Even though economists disagree on the details of various techniques, various methods give similar results and serve the broad purpose.

To make the job of economists easier, statistical departments in advanced countries release seasonally adjusted data in addition to the raw data. These numbers are then picked up by the media, the central bank for policy analysis and by the government for its communication with policy-makers.

Despite the obvious advantages of watching seasonally adjusted monthly inflation data which have been pointed out by Indian economists for many years, it is unfortunate that the government of India still does not produce and release seasonally adjusted data. In a recent study at NIPFP we find evidence of the crucial early warnings which would have emanated from monthly data. For example, inflationary pressures were visible from January 2008 when the data for December 2007 was released. While the headline inflation numbers jumped up only in March, the trend was visible from December 2007. Inflationary pressure continued to grow after that. If monthly data had been tracked, the December data (that is out by mid-January) would have rung alarm bells. This would have stopped RBI on its tracks in its purchase of USD 21 billion in the spot and forward markets in January 2008. It would then perhaps also not have bought another USD 11.16 billion till the end of May 2008. This not only pushed the rupee to weaken, making the rupee price of global commodities even higher, but it also added to money supply.

There is also a risk of missing the good news with year-on-year data. In the mid ’90s when seasonally adjusted monthly inflation was already showing signs of prices having been brought under control, year-on-year inflation continued to be high. RBI, unaware of this good news, kept on tightening monetary policy. This appears to have kept monetary policy tight for too long.

As long as the focus of monetary policy was on keeping exports competitive through manipulating the rupee-dollar rate, RBI could conduct monetary policy without the analytical arsenal normally used by modern central banks. However, as the Raghuram Rajan and Percy Mistry reports point out, today the contradictions between a policy that focuses on the exchange rate and a policy that focuses on reducing inflation has become so sharp that RBI needs to reform itself into a central bank that focuses on inflation. In this setting, the intellectual tools for understanding the inflation process have to be sharpened. Among other techniques, an improvement in the measurement of inflation and in understanding the inflationary process must be an important element of the reform undertaken. The CSO can contribute to this process by releasing improved inflation data and tracking monthly changes in prices.

The writer is senior fellow, National Institute of Public Finance and Policy

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