ECONOMIC Understanding the inflation trends in India

RESEARCH

July 16, 2008 Rising inflation level is a major issue worrying all the countries. This report is an attempt to
study the inflation trends in India.
Amol Agrawal
+91 22 66177921 Measures of Inflation
amol@idbigilts.com The inflation in the Indian economy can be measured in 3 ways:
1) National Income Deflator- This is defined as ratio of GDP at current prices and GDP
at Constant Prices. It is a comprehensive measure as it encompasses all the goods and
services produced in the economy. However, its application is limited as it is released
on a quarterly basis by CSO and then it comes with a lag of 2 months (e.g. figures for
quarter Jan-Mar 2008 quarter are released on 30 May, 2008). Further the GDP figures
are subject to revisions (though this applies to WPI as well) and together these factors
make it of little use for policymakers.
2) Based on Wholesale Price Index (WPI)- This is the most common measure of inflation
and is used for policy purposes.
3) Based on Consumer Price Indices- Within Consumer Price Indices, there are four sub-
indices that are based to capture price levels across different types of consumers. They
are:
a. CPI - Industrial Workers
b. CPI- Urban Non-Manual Employees
c. CPI- Agricultural labor
d. CPI- Rural Labor
Appendix 1 summarizes the main features of WPI and various CPI indices.

Long term trends in Inflation

! Long-term trends: Figure 1 shows overall inflation trends have declined from 1970s
levels. Inflation declines in 1980s, increases in 1990s compared to 1980s level but again
declines in 2000s. Inflation has nearly halved in 2000s compared to 1970 levels and this
is common across all measures of inflation except WPI-Fuel. Apart from the absolute
inflation number, another important indicator is volatility in the overall inflation trend.
High volatility implies estimating inflation in future becomes difficult and this makes
anchoring inflation expectations very difficult (To understand inflation expectations refer
IDBI Gilts report dated 30 June 2008).
Figure 1: Inflation in Decades (%)
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
1970s 1980s 1990s 2000s
WPI WPI- Primary WPI- Fuel
WPI- Manufactured CPI-IW CPI-UNME

Note: Inflation is measured as average inflation in the decade

Source: RBI; Labour Bureau; CSO; IDBI Gilts Limited
 Economic Research: Inflation trends and Impact of Monetary Policy

Figure 2 analyses the volatility of the inflation trend and again the picture is similar to the overall
inflation trend. Infact, in this context the performance of the policymakers is more exemplary. The
volatility has declined from 9% in 1970s to 1.32 in 2000s and these 1% levels are noted across most
inflation measures. Again, the volatility continues to be high in WPI- Fuel index.
The trends seen in WPI- Fuel are in line with the broad thinking over whether to include fuel
prices (along with food prices) in the inflation indices. As these prices are very volatile, the
policymakers prefer to target core inflation that excludes fuel and food prices. However, this also
puts policymakers in an artificial comfort zone as core inflation will not show the rise in the food
and fuel prices and if it continues to be permanent, the actual inflation in the economy will be
much higher than targeted/preferred figure.
Figure 2: Inflation Volatility in Decades (%)

20.00

15.00

10.00

5.00

0.00
1970s 1980s 1990s 2000s

WPI WPI- Primary WPI- Fuel WPI- Manufactured CPI-IW CPI-UNME

Note: Volatility is measured by Standard Deviation

Source: RBI; Labour Bureau; CSO; IDBI Gilts Limited

Impact of monetary policy measures on inflation

This is perhaps the most important issue in everyone's minds- When will inflation come down from
11.5% plus levels? Though, there are number of fiscal policy measures taken along with monetary
measures to ease inflation, the focus is largely on monetary policy. This section reviews the impact of
monetary policy on previous bouts of inflationary pressures.
Figure 3 looks at the impact of various policy rates on the inflation. The repo and reverse repo tools
were introduced in 2000 and Bank rate has not been used since the last time it was changed in 29 April
2003. The focus since then has been on using a mix of repo, reverse repo and cash reserve ratios. It is
very difficult to specify which monetary measure has been more effective to manage inflation as usually
a mix of measures are taken. However, an analysis needs to be done to understand the impact of
monetary measures on inflation.
Figure 3: Impact of various policy rates on WPI
20.00%

15.00%

10.00%

5.00%

0.00%
01/04/95

01/04/96

01/04/97

01/04/98

01/04/99

01/04/00

01/04/01

01/04/02

01/04/03

01/04/04

01/04/05

01/04/06

01/04/07

01/04/08

WPI Bank rate CRR Reverse Repo Rate Repo Rate

Source: Economic Advisor to Commerce Ministry; RBI; IDBI Gilts Limited

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Economic Research: Inflation trends and Impact of Monetary Policy

To make the analysis more contemporary, we analyse the data from 2000 onwards when repo and
reverse repo rates were introduced. Appendix 2 summarises the developments. Overall, it is noted that
inflation trends in India have been very volatile. Though, volatility has declined compared to 1990s and
1980s, still the trends keep changing making monetary policymaking a tough and a complex task. RBI
has used variety of tools to manage inflation and the monetary policy process itself has changed over
the years. Earlier the focus was on Bank rate and it has since then shfted to repo and reverse repo rates.
The policy stance also becomes clearer with time and become more preemptive from 2004 onwards.
For instance, RBI raised rates in looking at rise in current inflation and in 2006 it raises rates expecting
inflation to rise in future. Even in 2008, when various economists and analysts were suggesting RBI to
cut rates, it didn't cut its rates as it was expecting inflation to rise. We can also see the monetary policy
working with a lag as measures taken in 2004 lead to lower inflation in 2005 (it takes about an year for
the effect) and measures taken in 2006 leads to lower inflation in 2007 (again takes about an year). In
both the cases, it takes about an year to lower the inflation but we can't pinpoint a particular measure
as there were a series of measures.

WPI Inflation -sticky or volatile?

! Importance of stickiness: In this section, we would want to initiate research in a subject which
is not talked about but has very important implications. This is stickiness in inflation trends. .
Stickiness is a situation in economics to describe a situation in which a variable is resistant to change
and continues to be around its previous levels. Another point to note is that stickiness normally
applies in one direction e.g. a variable that is "sticky upward " will be reluctant to drop even if
conditions dictate that it should.
This is actually expected, as prices don't change very often. The various items that form the
inflation index like prices of various manufactured products etc. don't change very often. Similarly,
an indirect component like wages that leads to build up in costs and then in product prices, are also
not revised very often. The companies also change prices looking at their competitors and usually
make decisions after taking the others decisions into account. This implies two things- one, the
actual inflation may be lower than it should actually be as prices have not risen and two, it might
take more time to bring the inflation to acceptable levels. Both the situations are very tricky for the
policymaker. In the first situation, the inflation expectations are building up and in the second, the
policymaker is never sure whether the policy actions taken so far have been enough
Figure 4 shows overall trend and again we can see the volatility in WPI- Fuel Index. However, on
a closer look at the WPI index separately (figure 5), it is noted that the inflation numbers are quite
"sticky" as peaks and bottoms persist and do not change very randomly.
Figure 4: WPI-Inflation in India (YoY) (in %) Figure 5: Inflation based on WPI

50.00% 14.00%
40.00% 12.00%
30.00% 10.00%
20.00%
8.00%
10.00%
6.00%
0.00%
-10.00% 4.00%
2.00%
01/04/95

01/04/97

01/04/99

01/04/01

01/04/03

01/04/05

01/04/07

0.00%
01/04/95

01/04/97

01/04/99

01/04/01

01/04/03

01/04/05

01/04/07

WP I P rim a ry Artic le

F ue l, P o we r & Lubric a nts M a nufa c ture d P ro duc ts

Source: Economic Advisor to Commerce Ministry; IDBI Gilts Limited Source: Economic Advisor to Commerce Ministry; IDBI Gilts Limited

! Analyzing Stickiness in WPI Inflation: To analyze the stickiness an exercise was undertaken to
see how previous inflation figures are related to the current inflation figures. The research
methodology is explained in Appendix 3. Table 1 presents the results of the exercise on WPI
index (week 1 one means 1 week prior to the current week and so on.)
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 Economic Research: Inflation trends and Impact of Monetary Policy

If we take week one numbers it implies on an average the difference between previous week and
inflation number is 0.004 and in week twenty the average difference becomes larger at negative
0.08. This means if inflation is 10% in current week, then it could be around 9.97% in week 1 (on
an average) and 10.08% in week 20 (on an average). This might indicate that trends are quite similar
even uptil 20 weeks as there is hardly much difference. However, standard deviation shows that in
week one the dispersion is much lower and this increases as we go towards week 20. This means
the numbers are highly dispersed and the trend becomes weaker as we move towards week 20.
Another important point to note is that both maximum and minimum values also increase with
each previous week. The means if inflation is 10% in current week, then it could be around 12.3%
(taking maximum) or 8.3% (taking minimum) in week 1. In week 20, it could be 16.6% (taking
maximum) or 4.4% in week 20 (taking minimum). On doing a similar study for quartile values, we
get a similar answer- more variation towards week 20 than week 1.One should also note that upto
5 previous weeks the trend is similar and then it reverses from week 6 onwards.
Table 1: Understanding Stickiness in WPI inflation numbers
Average Median Standard deviation Max Min
Week 1 0.004 -0.003 0.347 2.295 -1.730
Week 2 0.006 -0.008 0.515 2.805 -1.828
Week 3 0.005 0.000 0.651 3.177 -1.985
Week 4 0.003 0.036 0.771 3.322 -2.528
Week 5 0.001 -0.002 0.883 3.605 -2.921
Week 6 -0.002 0.019 0.994 3.590 -3.613
Week 7 -0.004 0.001 1.089 3.811 -3.898
Week 8 -0.007 0.001 1.173 3.710 -3.743
Week 9 -0.010 0.020 1.252 3.655 -3.681
Week 10 -0.012 0.045 1.324 3.951 -3.830
Week 11 -0.015 0.029 1.397 4.182 -3.967
Week 12 -0.020 0.051 1.473 4.276 -3.857
Week 13 -0.024 0.060 1.545 4.176 -4.129
Week 14 -0.029 0.057 1.615 4.837 -4.129
Week 15 -0.034 0.062 1.684 5.354 -4.070
Week 16 -0.041 0.032 1.747 5.726 -4.070
Week 17 -0.049 0.002 1.807 6.072 -4.412
Week 18 -0.056 0.018 1.864 6.444 -4.986
Week 19 -0.066 0.042 1.916 6.681 -5.354
Week 20 -0.075 0.019 1.964 6.635 -5.626
Source: Economic Advisor to Commerce Ministry; IDBI Gilts Limited

Likewise, a similar exercise has to be done for the WPI sub-indices - Primary Articles, Fuel Group
and Manufactured Products. A casual analysis indicates both primary articles and fuel group are
highly volatile and it is difficult to form any expectations for them. However, trends in inflation
based on manufactured products appear to be pretty sticky with numbers. This is in line with the
main idea noted above that prices of products tend to be sticky and these drive the inflation in
manufactured products.
In sum, the above results imply that the stickiness is higher in weeks closer to the current week.
However, many questions still remain e.g. we can't really define stickiness as we don't know what
number/range would say this is stickiness in Indian conditions. The study also has to measure
stickiness in deflation and inflationary times separately. Then there is a need to refine the methodology
with more sophisticated techniques and a comparison with other countries needs to be made. It
has important policy implications and more research has to be undertaken to understand the
process. If better techniques show stickiness is persistent, then it also shows why we see monetary
policy working with a lag as monetary measures take time to shift stickiness from one level to
another.

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Economic Research: Inflation trends and Impact of Monetary Policy

Conclusion
The above analysis points to some broad ideas on India's inflation. One, the inflation levels and volatility
in inflation have declined over the years. Two, monetary policy stance has become clearer over the years
and has become more preemptive. Three, inflation levels appear to be sticky especially towards the
short-term and tend to stick to a particular trend (however this needs more analysis). Though, the
analysis needs to be improved to understand both the stickiness and impact of monetary measures. We
would also like to reiterate that past is not a guide to the future and the latter could be completely
different from the past. So, we cannot say as this has happened in the past, it is likely to happen in future
as well.

Appendix 1
WPI CPI-IW CPI UNME CPI AL CPI RL
Base year 1970-71, 1980-81, Upto Dec 2005 base 1984-85 1986-87 1986-87
1993-94 year=1982; after Jan 2006
new series with base yr =2001
Population group All India; nothing Industrial workers relating to Consumers in non HH of HH of rural labour
specific factories, mines, railways, manual jobs agricultural
electricity companies etc in non agricultural labour
sector
Centres Various sources – 76 (1982); 78 (2001) 59 (34 common 20 states (600 20 states (600
collected from 259 with IW) villages) villages)
places
Coverage: Goods & Manufacturing 63.75
Services with Fuel - 14.23
Weights Primary - 22.025
Food, Beverages 60.15 (82), 48.39(2001) 47.13 72.94 70.47
and Tobacco
Fuel & Light 6.28,6.42 5.48 8.35 7.9
Housing 8.67,15.29 16.41 - -
Clothing & Footwear 8.54, 6.58 7.03 6.98 9.76
Miscellaneous 16.36, 23.32 23.95 11.73 11.87
Total 100 100 100 100 100
Source of data Office of Economic Labour Bureau CSO Labour Bureau Labour Bureau
Adviser (under
Ministry of
Commerce)
Source: RBI; IDBI Gilts Limited

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 Economic Research: Inflation trends and Impact of Monetary Policy

Appendix 2: Summary of Inflation and Monetary measures post 2000

Inflation Bank Rate Reverse Repo Repo CRR Remarks

2000 Increasing trend. Bank rate was 8% in It was introduced in It was introduced The CRR was The Policy stance
Increased from 3.04% Jan-00 and then was July -2000. It was in June-2000 and changed 4 times. It was not very clear
in Jan-00 to touch lowered to 7% in changed 22 times in was changed 19 was first lowered in this year. The
8.7% by Dec 2001 April-2000. This is the year. In the first 6 times. The moves from 9% levels and inflation levels
surprising given the moves, the rates were here were very was then lowered almost tripled but
fact that inflation was increased from 7% to volatile and there to 8.00. It was policy rates were
rising. The rate was 15.5%. It was was not a again increased to lowered.
again increased in July lowered in the next consistent trend. 8.5% levels
to 8%. 16 and rates touched The rate started
8%. with 9.05% and
was noted at 10%
in December

2001 In 2001, inflation Bank rate was changed It was changed 4 This was changed 3 The CRR is The Policy Stance
started to decline and thrice in this year. It times. The rates were times. Lowered changed five times. becomes clearer. As
reached 1.83% by Dec - was lowered from 8% lowered from 8% in from 10% in Jan- It was lowered to inflation rates have
2001. in Jan-01 to 6.5% in Jan-01 to 6.5% in 01 to 8.50% in 5.5% in Dec-01 declined, rates have
Oct-01 May-01. June-01 from 8.5% levels been lowered

2002 In 2001 inflation was The Bank waste was Changed three times Changed two Changed two The rates were
very low. It becomes changed once. Lowered Lowered from 6.5% times. Lowered times. Lowered lowered as
more comfortable in to 6.25% in Oct-02 in Jan-02 to 5.5% in from 8.5% in Jan- from 5.5% in Jan- inflation could
2002 and increases Oct-02. 02 to 7.5% in 02 to 4.75% in have instead
gradually to 3.5% Nov-02 Nov-02 become deflation.
The moves avoided
the situation

2003 The inflation trend is This is the last time It is changed two It is changed two It was changed Here again, we see
highly volatile in 2003. Bank Rate was times. It was lowered times. It was once. It was the 2000 trends.
It increases from 3.5% changed. It was from 5.5% to 4.5% lowered from 7.5% lowered from The rates are
in Jan-03 to 6.6% in lowered to 6% in Mar- in Aug. to 7.0% in Mar. 4.75% to 4.5% in lowered when
Apr-03. It then declines 03. Jun. inflation is rising.
to 3.8% in Aug, and
again increases to
5.86% in Dec.
2004 The inflation is again – The rates are changed The rates are The rates are Overall, the rates
volatile as seen in 2003. once and are changed once and changed twice. It is were increased to
It declines from 6.5% increased to 4.75% are lowered to 6% increased to 4.75% counter rising
to 4.3% in Apr. It again in Oct. in Oct. in Sep and 5% inflationary trends.
rises to touch 8.7% in in Oct. Inflation trends
Aug and then declines have been very
to 6.5% in Dec. volatile.
2005 The inflation declined – The rates are changed Changed once and Not changed It shows that
from 6% in Jan to 3.6% twice. Both times it increased to 6.25% measures taken in
in Aug. It again was increased to 5% in Oct 2004 led to decline
increased to 4.6% by in Apr and 5.25% in inflation in
Dec in Oct. 2005. RBI also
raised rates in Oct
expecting inflation
to rise.
2006 The inflation declined – The rates are changed The repo rates are Increased once to Clearly, RBI
to touch 3.7% levels in thrice. Increased by changed 4 times. 5.25% in Dec. expected inflation
Apr and then rises 25 bps in Jan, Jun and Increased by 25 bps to continue to rise
persistently to touch Jul and was noted at in Jan, Jun, Jul and ahead and rates
near 6% by Dec. 6%. Oct. It was noted were raised. The
at 7.25% policy action was
preemptive.

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Economic Research: Inflation trends and Impact of Monetary Policy

Inflation Bank Rate Reverse Repo Repo CRR Remarks

2007 The inflation increased – No change Changed two Changed 7 times. RBI again raised
initially and touched times. Increased to Increased from rates as inflation
6.5% in Mar-07. It then 7.5% and 7.75% in 5.25% in Jan-07 to continued to
declined to touch Jan and Mar 7.50% in Nov-07. increase. The
around 3.8% by Dec. respectively monetary measures
helped lower
inflation.

2008 In 2008, inflation – No change Changed two Changed five times. Inflation was
surged substantially times. It has been Increased by 25 bps always expected to
from 3.8% in Jan to increased by 75 bps in Apr, 50 bps in rise tracking rise in
11.6% in Jun. The May and another fuel and
revisions also have been 50 bps to take commodity prices.
much higher. effect in Jul. However, double
digit inflation is
highly worrisome
and measures are
further expected
Source: Economic Advisor to Commerce Ministry;RBI; IDBI Gilts Limited

Appendix 3: Research Methodology

! We first put current inflation (at time t) with inflation of numbers of preceding 20 weeks (t-1, t-2 …..to t-20). 20 weeks
was taken as a random number just to asses the trends in that time period.
! Then we calculated the difference of each time series (from t-20 to t-1) with time series at time t.
! Then average and standard deviation of the differences in each time series is calculated to understand average change of
inflation with current inflation. Standard deviation is also measured to understand the dispersion in the series.
! Though, this is a very crude measure to understand stickiness, it is simple and gives some initial ideas which can be refined
for further analysis.

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