CPI or WPI?

Back after a really long gap. I was training to be part of the first team of astronauts from India to Mars. I failed to make the cut so am back now on this website. Only to discover that all my money that was parked in midcaps has all but disappeared while I was away! I should have made that trip, I now regret my failing the entrance tests. Isn’t it true that Mars is the ruling planet of all midcaps? fiery, combative and volatile. mangal ho sabka!

The other big news is that the lady that’s our household help is hoping to be a leg up over inflation and has therefore delivered a verbal notice (in Telugu) for a generous increase in her wages. Since we don’t understand Telugu, that’s what we understood her point to be. Surely, she follows the other Andhra gentleman who is also the RBI guv, who seems quite sure that dipping the repo isn’t really going to get general prices down. He means ‘consumer’ prices. If you remember, the earlier technicality was to do with whether inflation is ‘supply side’ or ‘demand driven’. RBI said supply side constraints were pushing up prices. Point being that an increase in production capacity and productivity would bring prices down. On the other hand, the finance ministry seemed to have said all along that tweaking the monetary levers would push prices down – a reduction in rates would get investment and spending cycle going and therefore Mumbai should reduce the repo rates. Now, the debate has shifted to which rate should one look at. The RBI guv points to the stubborn consumer prices and demands that the government of the day do some serious belt tightening while Delhi points out the recent decline in prices in the mandis and thereby makes a stronger case for rate cuts going forward.

So is it the wholesale prices (tracked by the WPI) or the prices that end consumers pay (tracked by the CPI) should one follow? The answer surely cannot be the very Indian, “it depends” since, after all, economic policy and long term planning (as also salary revisions!) depend on the rate chosen. Most countries use the CPI and have dropped the WPI from their economic planning game since the seventies. The RBI is proposing we pay more attention at the CPI and make that our official inflation rate instead of the WPI. It’s said that since the CPI tracks movement in prices at the ‘point of sale’ that is really what matters to a country’s citizens. General public cannot buy at mandis at wholesale prices. So therefore, lets change our official inflation gauge to CPI instead of being one the few countries (Pakistan gives us company) that remain fixated on the WPI. Personally, I feel that the WPI serves us well. We are predominantly an export driven economy. The other industrialized nations have made the transition to being completely consumer driven industries. So they track consumer price level changes. What is confusing to me is China’s decision to move away from WPI in favour of the CPI like the industrialized nations – I personally think it is very much an export driven producer economy (bigger version of India) and the consumer culture has not yet set in there.

CPI vs WPIIt’s really funny – in 2008, when the CPI in India was way lower (7%) than the WPI (12%), people (i.e. industry lobbies) were pointing to the high CPI and asking for a rate cut. Now they are pointing to the WPI and still asking for rate cuts. This led me to read up articles on the net to check if there is some cyclicality, causality or inter-dependence between the WPI and the CPI. The reason why the WPI and CPI are not moving in step is easy to understand – just look at the constituents of the indices to figure it out. There’s no rocket science or great economic mumbo-jumbo when the Prime Minister says that the food costs are running ahead of all else – more so, those of the protein based foods. Core CPI (ex food and fuel) has really dropped from 10.5% (in Jan’12) to 8% (in Jan’13) – so it’s pretty obvious that the reason why the CPI as a whole is still ruling at 10.5% is because of food and fuel. The weightage of food and fuel is very different across the WPI and CPI. The weights of the items that form the CPI basket are derived from their share in a typical consuming household. So things like imports and exports and wastage and storage (remember food stocks piled up in FCI godowns?) become critical factors that can make end buyer prices very different from producer prices. At a very general level, does it not mean that WPI + supply chain related affects = CPI? You get the idea, right? So I did two things – I looked up the internet and also plotted CPI and WPI values over the past 7 years to check if any patterns or correlation exists. Take a look at this paper which says that in India, the WPI leads the CPI. It points out that the WPI seems to be predicated by market forces and that controlling the factors affecting WPI can give a lever to controlling the prices at the consumer level. India’s per capita income, though low, is increasing and the nation’s consumption basket is slowly shifting towards non-core food items and hence despite the high weightage of food items in the CPI, it is unable to lead the WPI to a greater extent. So, while the paper does point to the presence of bi-direction causality, the impact of the WPI on the CPI is higher than that of the latter on the former. Also, WPI leads CPI which makes it the leading indicator of consumer prices and therefore eligible as a inflation planning gauge in the Indian context.

Repo Rate and Inflation

The Reserve Bank of India (RBI) has designated the weighted average overnight call money rate as the operating target of its monetary policy and the repo rate as the only independently varying policy rate in order to more accurately signal the monetary policy stance. So while cash reserve ratio (CRR), statutory liquidity ratio (SLR), market stabilization scheme (MSS) etc. are all important tools, the policy lever of RBI that is always in the spotlight is the repo rate. This is the rate at which banks borrow from the central bank blah blah…

A lot has been said about RBI’s role and its effectiveness in fighting inflation. Rate hikes are common knowledge to all in the country by now concerning that they affect people with loans in their lives. Interest rates have been rising in India (and all the emerging economies) and I had an investment thesis of catching banking stocks when the interest rate cycle turned. Interest rate senstive sectors like automobiles, real estate, banking etc. will get a breather if the rates turn. The sovereign debt crisis in Europe has however ensured that the hawks continue to circle above the Indian economic landscape. Fat chance that we may see a rate reversal. Indeed, the banking sector is badly mauled and it certainly does not look to be in a hurry to recover. I need to figure out what to do with my investment positions in Axis Bank and HDFC Bank – and towards that end I tried to read up and form an opinion on inflation, rates and their cycles. The below chart came out.

If you look at the period after mid-2008, there is a very perceptible negative correlation betweeen inflation measures and the repo rates set by RBI. I am saying correlation here. As you know, correlation does not automatically imply causality. I have shaded the three time periods of recent times where we can discern some sort of a clear monetary stand taken by the RBI. The light blue band is a period of declining repo rates. I have added a 12 period moving average of the monthly inflation rates (taken from ycharts) to show trending inflation information. As you can see, during this period, the inflation rate increased as the rate fell. Then the light yellow period (Nov’09 – May’10) shows the continuation of the trend started in the previous phase. The RBI further reduced the repo rate down to 4.75% towards the end of this phase – with inflation continuously rising while all this was taking place. Then finally, the green band, which we seem to be in today as well. Here, we all know the sequential repo rate increases affected by the RBI. The inflation rate did appear to have fallen from a high of 14%. But it is still high at 9.5% – 10.0%. So many experts (and some vested interests) have argued that the RBI should stop fiddling with the policy rates since these measures have not been successful in taming the beast. My point here is that inflation is whatever it is, but can you confidently say that the situation could not have been any worse than what it is today?

I guess, my view is that till this point successive repo rate increases have helped in “controlling” inflation. They may not have brought inflation back to the comfort zone of 5% – 6%, but they have definitely put some brakes on the juggernaut. Beyond this point, any further increases in the policy rates may actually be detrimental to the economy (from the inflation point of view)! Beyond a point, if rates continue to rise, they will do their bit to strangulate the supply side by making it uneconomical to produce. While you may smile when you read about farmers in Andhra Pradesh striking work, the fact of the matter is that very high rates do push out payback times, reduce rates of return on economic activity and shut down the cogs of industry. I would not be surprised if the increasing levels of cash balances with Indian companies is linked to them not finding any profitable incentive to produce/invent and invest. So, my hunch is that RBI will/should stop raising rates now. However, my holding in Axis Bank and HDFC Bank is still a millstone around my neck since a pause in raising rates does not mean that the central bank will start reducing them! It could be a good 6 months (if not more) before we start seeing a reversal of the current policy regime.

So what about inflation? Maybe we hope that foreign policymakers and governments are more adept than ours. FIIs run our stock markets by proxy anyways. If the cost of fuel starts falling and INR goes up (read as: USD depreciates since Americans would want Germans to continue buying American exports) then perhaps inflation will take care of itself. This will happen inspite of our Government which has done absolutely nothing to control the supply side pressure to inflation. In fact, people posture and talk as if the RBI is responsible for the supply side as well! We are in a hot air balloon now. Lets enjoy the expansive expensive view from the top. 🙂

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