India may need to reconsider its indicator for inflation targeting

The government could re-examine its 2016 legislative mandate and modify RBI's inflation target to cover both WPI and CPI

- T.C.A. ANANT

In my last article, I had discussed the different measures of inflation and closed by pointing out that the divergent behaviour of the Consumer Price Index (CPI) and Wholesale Price Index (WPI) creates a challenge for monetary authorities. In order to understand this issue, it is worth taking a step back to understand recent developments in monetary policy in India.

India adopted an inflation targeting regime in 2015, initially as an agreement with the Reserve Bank of India (RBI) and subsequently through an amendment to the RBI Act. This decision was based on a recommendation of the Urjit Patel Committee to the RBI in 2014. This panel also recommended using the CPI produced by the Central Statistics Office as the indicator for this purpose. Till then, RBI had used WPI as the main indicator in monetary policy discussions. The reasons for choosing the CPI over WPI were that the latter did not capture price movements in services, and that CPI better captured the inflation experience of consumers. Another factor in favour of the CPI was that it showed similar inflation momentum to the CPI-IW (a CPI for industrial workers which is widely used for Dearness Allowance adjustments for both government and public sector employees), but was released much faster, and also had a robust price reporting mechanism.

One of the elements behind the choice of CPI as an indicator for inflation targeting was the feeling that it would be better able to reduce households’ inflation expectations. In this connection, the committee made the following curious observation: “An examination of the quantitative inflation expectations of households shows that inflation expectations tended to follow WPI inflation during 2008-09. Post-2011, however, they seem to be following CPI inflation." (Para II.33)