Inflation not only increases your grocery and fuel bills but also taxes your savings. In April 2006, had you invested Rs.1 lakh in a five-year fixed deposit at 8 per cent per annum, inflation would have ensured you received only 94 per cent of the principal originally invested. Confused? With inflation at 9.1 per cent on an average, even with the 8 per cent interest you earned every year, the Rs 1 lakh you invested would have lost 6 per cent in purchasing power terms. With higher inflation, an individual has little or no incentive to postpone his consumption.

Background

In order to rein in inflation the Reserve Bank of India (RBI) raised interest rates amid a barrage of protests from corporate India. This has, however, met with limited success, thanks to factors beyond the RBI's control — supply shocks and global commodity price spikes. However individuals and investors should bear in mind the fact that even as the Wholesale Price Index (WPI) is on top of everyone's mind, it is the consumer price index or CPI which affects them the most.

If the WPI were to fall, will this automatically translate into fall in CPI? While the WPI reflects prices collected by agents reflecting wholesale price movements of 676 commodities at key trading centres, CPI captures the retail price movement of both goods and services at specific retail points. The CPI in turn is derived from two sub indices CPI- IW (Industrial Workers) and CPI- AL (Agricultural Labourers). In India, WPI is used as a headline inflation number, by policymakers such as RBI, given the faster availability of reliable data and the wider coverage of commodities in the index. Headline inflation looks at the movement of food and fuel prices, whereas core inflation looks at the rest.

The higher weight to manufacturing products also reduces the volatility of WPI relative to the CPI. Lack of a single CPI measure to represent the whole population until recently also acted against its use as a headline measure.

Weights differ

A key difference between CPI and WPI is the weightage each index gives to different segments such as food, fuel and manufactured goods. For instance, the new WPI, which came into effect from September 2010, gives a 65 per cent weight to manufactured goods. The food and food products account for only 24.3 per cent of WPI.

In contrast, the CPI has a 46.2 per cent weight in food and food products, while manufactured products account for a much lower weight. This makes CPI indices more susceptible to the volatility in the food prices — in 2009, for example, when the food prices spiked on the back of bad monsoon and shortage of foodgrains. CPI-IW then witnessed double digit inflation for the entire year ended July 2010. The WPI remained rather muted in this period, going into double digits only from March 2010. The CPI- AL, which has the highest weight to food products rose as high as 17.6 per cent during this time.

Fuel and light products have weights of 15 per cent in WPI while the CPI weights ranged between 6.4 and 7.9 per cent. With majority of fuel and light products subsidised, this segment of the CPI tends to be less volatile.

If CPI ran ahead of the WPI inflation for much of 2009-2010, the tables have turned recently. Since January 2011, WPI inflation for the first time in two years has overtaken CPI inflation, a clear indication of the inflation shifting from primary articles to manufactured goods. Average CPI-IW inflation during the calendar years 2009 and 2010 was 10 per cent and 12 per cent respectively. Inflation on the WPI was just 2.4 per cent and 9.6 per cent in these years, In the first four months of 2011, the average CPI IW inflation was 9 per cent while WPI was higher at 9.33 per cent.

New CPI index

In order to give a better picture of the price movements a new CPI index with base year 2010 was introduced in February 2011. The new urban CPI has lower weights for food while housing and transportation & communication were given higher weights.

The rural CPI also saw lower weights for food with education, healthcare, personal care, transport and medical care getting increased focus. In the new CPI, the rural and urban indices can be separated and carry weights of 56.6 per cent and 43.3 per cent. These are aggregated to a common CPI.

The transition to single reconstituted CPI has multiple advantages

One, the new inflation data is provided by the Ministry of Statistics and Planning (MOSPI) while the CPI-IW data is provided by the Labour Ministry. This means quicker dissemination of the CPI index.

Today policy decisions taken for monetary actions by the RBI consider WPI as a headline indicator. If the dissemination of CPI improves, RBI too may consider using it as the headline indicator, in keeping with worldwide practise.

That's good news for consumers, who can expect interest rates to more closely track the inflation experienced by them. The weights taken from the consumption survey will be revised in 2011-12 to meet the current consumption pattern making it more representative to consumers/individuals.

With a single CPI, an investor may find it easier to benchmark his returns to inflation. Now all we need is an inflation indexed bond product that can combat inflation risk and help investors lock into a positive real return.

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