Inflation is a sustained rise in the general level of prices of goods and services over a period of one year. In other words, it indicates the percentage rise in the general prices today compared to a year ago. The rise (fall) in inflation mans that purchasing power of money declines (increases). This measure is very useful in understanding the trends in cost of living and also in comparing the trends in major macroeconomic variables. From the policy point of view, particularly for the monetary authorities, tracking of inflation is quite essential in formulating necessary growth policies.

In the recent period, India has been witnessing very high inflation rates and this has become a serious policy concern as it could have adverse impact on both growth and welfare of the country. The recent data shows that the headline inflation in May 2010 is at 10.16%, against the RBI’s comfortable level of around 5%, as stated in the April 2010 Annual Credit Policy statement. In this context, here we look into the recent trends in the inflation rates (both headlines and also the subcomponents) and the main drives of these high rates. In the end, some discussion on the policy options that might help in containing inflation would be specified.

RECENT TRENDS

Before we look into the recent trends in the inflation rates, we need to understand the existing measures of inflation. As in any economy, India also has two broad estimates that cover the prices in whole sale market (which is called Wholesale Price Index (WPI)) and the retail market (Consumer Price Index (CPI)). Within CPI there are three sub indices that cover three groups namely industrial workers, urban non-manual employees and agricultural laborers. But there is no consolidated CPI for the whole economy. In the case of WPI, the index covers only the prices of goods and not the services, thus, making difficult for the policy makers and researchers in choosing the appropriate price index for target and also for research. However, WPI is the one that is tracked by the analysts and policy makers as the information flow is faster with WPI compared to CPI, which comes with a lag of two months.

It is also generally assumed that any changes in the prices in wholesale market would eventually transmit (or pass-through) to the retail market. Hence, WPI might be a better indicator for tracking the general price level in the economy. However, a look at the graph below shows that the convergence between WPI and CPI inflation is quite weak, particularly during the high inflationary periods, and also takes a long lag. Thus, this divergence in price indices also results in divergence in the policy impacts as well.

The recent trends in the inflation numbers show that India is experiencing high inflation situation since the end of 2009 and currently it is at an uncomfortable level of 10.16% in May 2010 and there are expectations that this would increase further. At the disaggregated level, one may note that the prices of both food and non-food and the fuel group are increasing sharply since the middle of 2009, while the inflation rate in the manufacturing sector was almost subdued at around 6% for a long time. As minimum rise in the inflation rate acts as an important incentive for the production activity, this could have adverse impact on the consumption and could particularly affect the poor who are largely not indexed in India. Based on this, our own studies in the past have shown that the threshold (or the optimal or tolerant) inflation for India is at around 4 to 4.5%. Policy makers (particularly the monetary authorities) would try to contain the inflation at around this range. Although India does not follow the inflation targeting regime (where the inflation rate should be controlled at a level fixed by the legislation.

For instance, UK has fixed the inflation target at 2%), it is generally clear from the policy statements (such as manual Credit policy) that the Central Bank would try to control the inflation once it crosses the ‘comfortable level’.