The Wholesale Price Inflation (WPI) index has historically been the price index monitored by Indian policy makers. As a measure of inflation, WPI has two critical shortcomings. First, it does not cover the price of services. This means that WPI does not capture changes in prices of house rent, medical check-ups, hospitalization, mobile telephony services, school fees, or any of the services that collectively make up at least one third of the average consumer budget. Second, WPI is made up of wholesale prices, rather than the actual retail prices at which items are purchased in the market by the end-customer. Obviously, WPI inflation was never a good proxy for the cost of living, but the fact that it was compiled and released on a weekly basis made it the inflation index of choice^[1].

The importance of WPI has not reduced, despite the availability of the new monthly Consumer Price Index (CPI) from January 2011. The Central Statistics Office compiles separate CPI indices for the urban and rural population, as well as a combined national level index. The new CPI represents the retail consumption basket much better than WPI, because it covers both goods and services, and the weight assigned to each item is based on a survey of actual consumption expenditures^[2] (see Pic 1). Additionally, it is based on retail prices culled from the market, so it includes taxes and duties actually paid by consumers.

Pic 1: Composition of WPI and CPI

Source: CSO

Yet policy makers are slow to discard WPI for CPI. The main reason is its newness, or the fact that there are only 19 data points for CPI inflation (from Jan 2012 to Oct 2013). Statistical tests need at least 30 observations to be accurate; and the available data set of CPI is too small for rigorous analysis. For instance, one cannot run a regression to measure the impact of interest rates on prices and GDP; as a result RBI cannot use past trends to assess the impact of policy changes on CPI.

The two inflation indices do not always move together: this creates confusion about inflation trends. On an average, the differential between CPI and WPI inflation is about 3%. However, during March 13- June 13, it widened to a massive 4.7%, as WPI fell much faster than CPI (Pic 2).

Pic 2: CPI, WPI, and their differential

Source: CSO

The ex-RBI governor, Mr.D.Subbarao, recently pointed out that the difference between CPI and WPI was the result of "statistical differences stemming from coverage, classification of items and the relative weights of their constituents"^[3]. Much of the divergence is explained by the relatively higher weight of food items in CPI. Since inflation in recent years was largely caused by food prices, retail inflation tended to be higher than wholesale inflation. RBI studies have shown that WPI and the old CPI index for Industrial Workers (known as CPI-IW) moved together in the long run^[4]. Thus it is possible that the differential with the new CPI will also narrow over time. But in the short run both indices will need to be watched carefully.

As market watchers scrutinize the two indices for clues to policy action in the December 2013 review of monetary policy, two points must be noted. First, retail prices tend to lag wholesale prices because producers pass on price rises to consumers after some time^[5]. If demand is strong, price hikes can be passed through easily. But in a situation of weak demand, producers may opt to hold prices constant. But whatever the demand situation, a consistent rise in WPI would force producers to increase retail prices. In October 2013, WPI inflation reached 7%, the highest level this fiscal year. If this rise is sustained, CPI (which is already 10%) would rise too in the coming months. This will make it tough for RBI to lower interest rates in the near future. Second, India is one of the few emerging economies facing inflation; most are struggling to manage deflation. That food inflation can occur despite a good monsoon clearly indicates that infrastructure for distribution of agricultural produce is weak. Strengthening agricultural supply chains should be a priority; otherwise the country will be caught up in chronic inflation cycles