The Monetary Policy Committee (MPC) of the Reserve Bank of India RBI echoed a sentiment of careful optimism as it chose to maintain the repo rate at 4 per cent. Notably, this sentiment was also reflected in the Economic Survey as well as the Budget announcement.

As growth rates rebound from the effects of the pandemic, the RBI predicted a real GDP growth rate of 7.8 per cent for 2022-23. On the other hand, the Survey predicted an 8-8.5 per cent real GDP growth rate.

While this certainly comes across as good news, inflation — particularly the Wholesale Price Index (WPI) — may play spoilsport and the actual out-turn may deviate considerably from the forecast due to WPI volatility alone. The GDP deflator, the so-called economy wide aggregate price index, is a derived indicator. Various components and sub-components of nominal GDP and subsequent conversion to real GDP use different price indices.

In their present form, these conversions are heavily influenced by both WPI and CPI movements. Therefore, attaining a particular real GDP growth target is contingent on attaining desirable levels of both CPI and WPI inflation. In this context, understanding the recent divergence between WPI and CPI inflation is important.

For its 2022-23 outlook, the RBI’s MPC statement maintained that “the potential pick-up of input costs is a contingent risk, especially if international crude oil prices remain elevated.” So far, the wholesale price inflation — which is a summary measure of input cost inflation — continues to remain steadily high.It reached a three-decade high of 14 per cent in November 2021, even as CPI inflation remained in the upper corridor of the target zone.

A closer inspection of the WPI reveals that all its sub-categories reflected high inflation throughout the third quarter of 2021-22. Of these, manufactured products on average contributed towards 47 per cent of the observed inflation. Also, the fuel inflation showed the highest growth. For instance, High Speed Diesel (HSD) — which is the wholesale term for diesel — grew by a whopping 86 per cent in the month of November 2021.

Base effect

Why has there been a steady rise in wholesale inflation (Chart 1), even as retail inflation remains relatively tame?

A part of the double digit WPI inflation can be explained by the presence of strong ‘base effects’ that were borne out of the pandemic. Note that ‘base effects’ are not necessarily a statistical artefact. The purchasers face different relative price pressures at different time points, which have differential welfare impact.

A quick look at WPI and CPI inflation after March 2020 reveals that WPI remained in the negative zone for a whole quarter after the first lockdown as opposed to the CPI which registered consistent positive inflation. Sub-categories within the WPI exhibited a similar trend with wholesale prices for food, manufactured products and fuel remaining tame throughout the pandemic.

Therefore, as the WPI recovers from its 2020 low, base effects are bound to set in creating a large inflation figure. However, base effects alone do not explain what in fact is also a ‘catching-up of whole-sale prices’ with their retail counterparts. At the basic matching item level, there should not be large variation as both reflect changes in price relatives.

Chart 2 shows inflation for items common to both the CPI and WPI indices. These items make up 73 per cent of the CPI index and 34 per cent of the WPI index.

It can be observed that, with the exception of the pandemic period, the wholesale and retail inflation for these goods closely track each other. Over the last quarter, wholesale price inflation for these similar items have begun to surpass retail price inflation. This indicates the possibility of higher wholesale price inflation even as base effects wear off.

Effect of rise in WPI

Since the RBI’s stance is contingent on a tame CPI inflation, what would be the effects of a sustained uptick in wholesale prices? Firstly, there would be a pass-through to CPI inflation. This could lead to CPI inflation going beyond the benign 4.5 per cent projected for 2022-23.

Secondly, this could result in downward corrections to real GDP projections due to higher CPI inflation itself. Along with this, juxtapose the possibility of higher WPI inflation. For instance, assuming a nominal GDP growth projection of 11 per cent with the real GDP growth projection of around 7-8 per cent, one could arrive at a GDP deflator based inflation of around 3-4 per cent.

However, if the WPI inflation continues to remain in double digits, we cannot expect the GDP deflator based inflation to remain lower than 4 per cent. Therefore, while targeting a CPI inflation of 4 per cent is in line with accomplishing the inflation objective of the RBI, it is not enough to fulfil its growth objective unless WPI inflation is also contained at a lower level.

Keeping in mind the growth considerations, it makes sense to retain interest rates at the moment. However, the effects of a high wholesale price inflation are significant and can lead to bleaker projections for the economy.

Meera is a Research Associate, and Abhiman Das is Professor of Economics, IIM Ahmedabad.