Indian economy needs a core inflation measure

There are talks of the RBI hiking rates in the last quarter of 2009-2010. Even its own monetary policy statement sounded alert on rising inflation rates. Is inflation rising? I wouldn't be surprised if the RBI is actually alerting itself and the rest of the world on headline inflation and not core inflation. Former Governor Y.V Reddy also stated in 2006 that the RBI has added credibility and guided inflation expectations by adopting an explanatory approach to headline and underlying inflation in India. However, I see a lot of discretion and no rule to understand what these are.


Before heading off into what the monetary policy "prices" in, let us look at what core inflation is all about. In crude terms, core inflation is a measure of inflation which excludes volatile price movements. In other words, core inflation is the permanent rise in inflation not caused by any cyclical or temporary jump in prices. For instance the Fed uses the core Personal consumption expenditure index :

The chain-type price index for PCE draws extensively on data from the consumer price index but, while not entirely free of measurement problems, has several advantages relative to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of expenditures.

While discretion is needed in monetary policy, it may not be the best of tools in issues that can be clearly quantified and constructed. Core inflation is not rocket science to construct and anchoring monetary policy on inflation rules is not an undesirable goal.

In India, talks of core inflation have been lingering around for long. While it is true that the current measure of prices (both CPI and WPI) are not good representation of rate of change in domestic prices, it is important to understand that as the central bank, seasonally adjusted core inflation data may provide far more consistency to monetary policy than otherwise.

Is consistency in monetary policy desirable when prices are shooting up and down? Firstly, given the administered price mechanism in the country for oil and food, distortions in the market has already taken place. I call it distortion because there is no underlying economics to the price set for petrol (other than of course the balance sheet of oil companies) or for that matter on food. The Food Corporation of India could do much better in its distribution and storage processes and the cost of government intervention has been way too high. Neither has its intervention in food prices kept the food prices low. It might be important to differentiate commodities and services where prices are administered. Menu prices are inherently sticky in the short-run (The government does not and cannot change prices often). Secondly, an approach such as the Fed's would make much more sense as what the consumer pays for consumption is what needs to be tracked.

If the RBI has been concerned about price rise all along, they would have noticed the phenomenal rise in food prices long ago. These can be seen in the seasonally adjusted three month moving average graphs of various WPI components. In short, there is an impending need for a core inflation measure that captures adequately the underlying price changes in the economy.