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Wednesday, July 22, 2015

What is the role of WPI in monetary policy?

by Jeetendra.
The RBI just can't seem to catch a break. Try as it might, it just can't seem to escape controversy, even over issues that in other countries are not exactly controversial. Take the case of which particular inflation index the RBI should use as its target. For an entire decade, people debated ferociously over whether the target should be the  CPI or the WPI. Finally, about a year ago it seemed that all the arguments had been exhausted and a consensus had been reached that the CPI was best. So, Governor Rajan announced that henceforth the RBI would target the CPI.

Case closed? Not at all! It turns out that reports of the debate's death had been greatly exaggerated. On July 9 the Business Standard reported that a growing chorus of businessmen and analysts are complaining that CPI targeting has led the RBI astray, causing it to set interest rates too high. They want the RBI to target the WPI, which shows that prices are actually falling.

Did the RBI make a mistake? To answer this question one needs to go back to basics, and think about what monetary policy is trying to achieve.

The main goal of monetary policy is to provide a particular service to the population, the service of ensuring stable prices. This task is of such importance that the RBI was set up as a special institution, organisationally distinct and geographically separate from the government. When that set-up did not prove sufficient to safeguard low inflation, further reinforcements were put in place. The RBI adopted a formal inflation targeting regime, and the government in turn promised to provide the central bank with the operational independence needed to achieve the agreed inflation target. The Monetary Policy Framework Agreement, which was signed by Finance Secretary Rajiv Mehrishi and RBI Governor Raghuram Rajan on 20 February 2015, creates this formal arrangement. All this is being done because price stability is critical to the welfare of the population, especially the weaker sections who suffer badly whenever the prices of their necessities rise.

So far, so good. The problem comes when one needs to translate the universally agreed objective of price stability into a specific monetary policy stance. To do this, one needs three things. First, a specific measure of inflation. Second, a definition of what it means for this measure to be “stable”. And third, a framework (which could be based on an econometric model) for deciding what level of interest rates would best achieve the inflation objective.

In other countries, most of the debate has centred on the third issue, whereas the first two have proved relatively easy to address. Virtually all inflation targeting central banks define price stability as inflation somewhere between 2 percent and 5 percent. And they measure inflation using the CPI, because the objective is to improve consumer welfare, and the index that measures the price of consumption goods is the CPI.

In contrast, WPI is only distantly related to consumer welfare. For a start, it is unclear what the WPI is actually measuring. Its coverage is extremely limited, encompassing only the commodity-producing sectors and completely ignoring services, which constitute more than half of the economy. The few sectors that are included are then weighted according to their gross value of production, not their value-added. Consequently, the index is deeply unrepresentative of the economy.

But let’s suppose the RBI were prepared to ignore these theoretical issues. It would run immediately into some very practical difficulties. Since the WPI consists mainly of commodities, the movement of this index is heavily influenced by developments in world markets, which the RBI cannot control. The RBI cannot determine the dollar price of oil. And while it can influence the rupee price by controlling the exchange rate, this is a dangerous strategy, as the East Asian countries discovered at their peril in the late 1990s, when their exchange rate pegs collapsed in crisis. So, the reality is that the RBI cannot control the WPI, and should not try to do so.

Does that mean the RBI should just ignore the WPI? Not at all. Recall that achieving price stability – even if measured solely by the CPI – requires a framework for figuring out what level of interest rates is required to obtain this objective. And this is where the WPI does indeed come in, as do various other measures of prices.

Just not in the way that the analysts quoted in Business Standard argue. According to them, interest rates have been set on the premise that the economy and inflation are proceeding apace (as indicated by the rising CPI), whereas in reality manufacturers' prices are falling (as shown by the declining WPI). So firms are getting squeezed between high interest rates and low prices.

Firms may well be suffering from a profit squeeze. In fact, the corporate results suggest they are. But you can’t prove this by citing the WPI. That’s because the WPI does not measure output prices, the prices at which firms are selling their goods. The index that does this is the PPI, or producer price index, which unfortunately does not exist for India. Rather, the WPI is essentially a measure of input prices, because it consists mainly of commodities, which are largely inputs into production. Accordingly, a falling WPI actually increases firms' margins, improving their profitability. (Think: oil.) As a result, there’s no need, at least not from the falling WPI, to compensate firms in the form of lower interest rates.

That said, there is a kernel of truth in what the Business Standard analysts are saying. To see this, let’s go back to basics again. Very broadly, inflation occurs when aggregate demand exceeds aggregate supply. And aggregate demand is influenced by many factors, including many different price indices. Consumption decisions depend in part on interest rates adjusted for CPI inflation. Export demand depends partly on interest rates less export price inflation. And investment demand is influenced by the difference between interest rates and PPI and WPI inflation. Summing up all of these factors is impossible to do intuitively. That’s why central banks employ large econometric models to guide their policymaking.

So, in the end, the analysts quoted in Business Standard have a point. The WPI and its attendant data bank of price time series, should be taken into account, indeed perhaps is already taken into account, in the RBI’s policy-making framework. But it cannot be the object of this framework. The sole inflation target should be, indeed must be, the CPI. After more than a decade, it is really time to put this debate to rest.

1 comment:

  1. In the context of India having high interest rates for last few years while they are at all time lows in many other countries, doubts arise as to whether our policy is on track or are we trying to bring in a global theoretical construct while ignoring the uncomfortable practical aspects of the issue. Some of these are:

    (1) A comment is made that WPI can not be controlled by RBI. But that applies to CPI as well?
    (2) If monetary policy does not have control on many items like food, fuel etc, shouldn't one look at core rather than total ?
    (3) What is the large difference between WPI and CPI attributable to? Is this a normal phenomenon, say even in other countries or other EM economies? Does this differential have any implication for monetary policy?
    (4) Why can not RBI or CSI construct and manage a PPI if that is what is relevant


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