Is India calculating inflation wrongly? Economists V Shunmugam and D G Prasad working with India's largest commodity bourse -- the Multi Commodity Exchange -- have come out with a research paper arguing that the government urgently needs to shift the method of calculating inflation.

Commodity Online presents the research paper here:

The so far aam aadmi becomes a popular person in the country where the media and policy makers see an increase in inflation, and his hardships so far unnoticed would be highlighted. Though increasing inflation definitely impacts 'aam admi', does the number we read or hear in the media really reflects upon the 'aam aadmi's' overall spending basket? In India, we know that Wholesale Price Index is officially considered for measuring inflation and its effect on the consumption pattern of the common man in the country, so the question is whether WPI is the precise indicator of inflation especially when we talk about aam admi -- the ultimate consumers in our economy?

Basically WPI as its name indicates is designed to measure the changes in prices at the wholesale transaction of all the commodities; to measure the impact of primary and secondary sector prices on the economy as it is supposed to be an early indicator of global and domestic fundamentals getting passed on to the ultimate consumer and help policy makers to take precautionary measures rather than prescriptive actions.

The index on the opposite pole of WPI is Consumer Price Index -- which is oriented towards the budget of a family of a largely homogenous target population in any particular economy. Apart from carrying items in its commodity kitty that have more relevance to a particular class of masses (ultimate consumers) as compared to WPI, CPI even accounts the retail margins and taxation and levies at the retail level that would have a direct impact on the consumption pattern of our aam aadmi. In fact, with VAT being followed by all the states in the country, price differential at the retail level due to taxation effect is likely to decrease.

In a country where prices are still being influenced by the government policies directed down towards the retail side, there is a greater need to consider an index that reflects price movement at the retail level. WPI essentially measures price changes from the production side and not from the consumption side. Further, price changes in the service sector are not duly captured in WPI which forms an essential part of the consumption of everyone in the country.

For instance, services like health, transportation, telecommunication, education, etc. are not included in the WPI. Hence, the changes in the costs of acquiring services are not reflected in WPI movement. When we discuss about inflation as the measure of prices affecting our aam aadmi, why use WPI in the first place when we have a more relevant index 'CPI' that reflects the prices at retail level and that too with the focus on various classes of consumers. In fact, both have their benefits and limitations. Let's ponder on various other issues to identify the more appropriate index as a yardstick for inflation.

Globally, CPI remains the official barometer of inflation in many countries such as the US, UK, Japan, France, Canada, Singapore, and China. Of course, the constituents of the commodity basket for CPI measurement vary from country to country as is their consumption pattern. Though we cannot draw a fixed time frame with regard to reviewing the commodity basket and their weightage, the global comparison on how it is compiled showed that CPI calculation should be flexible enough to read the changing consumption patterns, migration pattern, social trends etc. In most countries mentioned above, their economic authorities review the commodity basket of CPI atleast every 4-5 years and also whenever it deserves a review.

In today's India, where people's life style and consumption pattern is changing so fast, there is every need to review the CPI constantly to make it a more appropriate tool to measure inflation besides the immediate need for the shift from WPI to CPI to help take effective policy decisions.

For instance, a recent article quoted that there is a change in consumption pattern related to protein supplements in the country between 1999-2000 to 2004-05, towards better quality - animal and soybean protein sources. The study said that despite an increase in the nominal prices of these sources aggregated together the annual per capita average intake of protein had remained the same. The study indicated that the biological value of protein intake had increased over the same time period despite the stagnation in protein consumption levels. Hence, weightage for items like egg, fish, chicken, etc. should go up while it can be slightly reduced in case of certain pulses. Hence, this strongly advocates the need for an index that captures the consumption pattern and demand pattern in various centers and aggregates it effectively. Recent instance of a similar happening in Germany indicated that there was a change in the trend with the proportion of food preserved in tins and glass containers declining and that of deep-frozen food increasing which was exactly captured by their CPI both interms of item and its weightage.

In case of non-food items in various countries, there is an increased weightage for telecommunications and extended coverage of modern information and communication technology products amid declining costs. Most of the countries referred above have even included health, recreation, and cultural functions, considering their share in the total expenditure of people. For instance, even the cost of 'Tummy Tucks' and 'Nose Jobs' form a part of the CPI in Spain used to measure inflation as their economic management authorities have felt that it had become an integral part of life of a common man in Spain. The Governments in most of these countries have extended the scope of indices to capture the price movement of frequently sought commodities or services and also that is in demand. This helps policy makers to keep a track of the expenditure and consumption pattern of its population, which facilitates them in their fiscal and monetary decisions related to inflation, liquidity in the system, and to check spiraling prices, etc. But, unfortunately this shift was overlooked and we still look at those items that are slowly becoming less important and voicing concern about increase in prices of some commodities which are loosing their share in total consumption.

While the governments in the other parts of the world are considering interesting but unusual commodities and services to ensure that their index is in line with the market trend, it is time that our policy makers to take a leaf out of these experiences some of the well managed economies to follow suit. It is not necessary that our indices should capture some unusual commodities or need not be impressive in terms of changing the commodity basket but it should be flexible enough to reflect the present trend.

Policy makers often track WPI as it indicates the price movement much in advance before the commodities hit the retail market to help them take required steps well in advance to smoothen the prices at the retail level. Theoretically, it could be right but in one of our analysis, it was not found so. The effect of Crude oil price basket on the CPI and WPI was analysed as it constitutes 14.226 per cent in terms of weights on a total scale of 100 in the case of WPI and around 5 in the case of CPI and also this being a chief influencing factor of inflation in the country. One of the interesting findings was the correlation between Indian Crude Basket (ICB) and 2-month lagged WPI was the highest at 90.81 per cent. In case of ICB and CPI, again the 2-month lag CPI is highest at 84.91 per cent.

This indicates that more or less both WPI and CPI reflect the effect of price movement in crude oil markets at around the same period. India follows an administered price mechanism in pricing of crude oil derivatives, thus preventing both the indices from getting influenced directly by the global crude oil prices. Yet theoretically, WPI should capture the effect of global rise in the crude oil prices well in advance over the CPI. The fact that it is not reflecting so, tells us that there is something wrong either in sourcing of data or in its compilation for the computation of WPI. Further, the volatility of WPI is 0.55 per cent while that of CPI is 0.82 per cent. This indicates that CPI which is closer to aam aadmi should be watched much more closely than the WPI to assess the impact of inflation on the common man.

An interesting dimension emerging out of this analysis is that, though there is a APM operating on crude oil derivatives, the effect of the prices at which the Indian Crude Basket is purchased is captured with a lag.

Hence, the lower crude oil prices in the global markets during the first two months of this year are expected to reflect on the inflation trends in the coming period. So, the policy makers need not be excessively worried about inflation as it is supposed to come down in the near future combined with the arrival of Rabi crops in the markets. This is supported by the fact that ICB had come down in the month of October and November, which is reflected in WPI for the month of December (valued at 207.9) and January (valued at 208.5).

Is it the right time to shift to CPI as the official indicator of inflation?

The answer might differ among various economists, but many of these facts and findings advocate that its time we think of a shift.

If the contention is that by all means WPI provides them with early warning signals, why not they look at the commodity indices being compiled by the futures exchanges and try strengthen trading in futures derivatives so that they can capture the essence of primary commodities while the major manufacturing entities and service providers shall provide periodic price data to the government to help them in effective price management.

It also does not mean that one should press for CPI out rightly as it has got its own limitations, except that what we want to drive home the point is that there is no gain without pain.

In any economy managed by democracy, there would be a stiff resistance to change, however, reforms should not take a back seat if it is for the betterment of the economy and its management.