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CRISIL Insight

Improving Inflation Marksmanship

CRISIL Insight

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An alternative core inflation indicator for India

A report by CRISIL Centre for Economic Research

CRISIL Insight

Analytical contacts
Vidya Mahambare Dipti Saletore Anuj Agarwal Director, Economy Research Economist Economist vmahambare@crisil.com dsaletore@crisil.com akagarwal@crisil.com

We would like to acknowledge the contribution of Rahul Srinivasan, Harshal Bhavsar, Rashmi Parab and Ranjana Balagopalan who helped in preparing the report.

Contents

Page

Key messages........................................................................................ 1 Objective of the paper ........................................................................... 2 Part I - Constructing an alternative core inflation indicator.................... 3 Part II - Desirable properties of core inflation indicator: Does CRISIL Core Inflation Indicator measure up? ................. 6

Key messages
n

CRISIL Research has released an alternative indicator of core inflation - CRISIL Core Inflation Indicator (CCII). CCII captures the underlying demand-side pressures on prices better and is more stable than the existing core inflation measure - non-food manufacturing inflation - which is the existing measure of core inflation. CCII can therefore supplement the existing indicators that influence the Reserve Bank of Indias (RBI) interest rate decisions. For the computation of CCII, we add back processed foods and take out base metals from the existing measure of WPI-based core inflation measure. Both measures exclude prices of primary articles and fuels from the wholesale price index. CCII significantly improves upon the current measure of core inflation. It reduces volatility by excluding base metals and captures demandside pressures more accurately by including processed food articles prices of which are primarily influenced by demand strength. In 2011-12, while the underlying trends of the two measures of core inflation have been similar, CCII has declined more sharply. Average CCII is likely to drop below 5.0 per cent in 2012-13 from nearly 7.0 per cent in 2011-12. Inaccurate measurement of demand pressures by the existing core inflation measure, we believe, adversely affected monetary policy actions in the past. While the average CCII was 4.2 per cent in 200910, the non-food manufacturing inflation declined sharply to 0.2 per cent. This delayed policy tightening till March 2010. CCII also has higher correlation with inflation measured by GDP deflator, the most comprehensive measure of inflation. This implies that overall changes in prices in the economy are tracked more accurately by the new measure.

CRISIL Insight

Objective of the paper

In this paper, we present a new measure of core inflation for India, which we believe tracks demand-side pressures on inflation in a more accurate manner as compared to the RBI preferred measure of core inflation. Part I of the paper explains the construction and rationale behind - CRISIL Core Inflation Indicator (CCII). It also discusses the difference between the two measures of core inflation and its policy implications. Part II of the paper elaborates on the desired properties of core inflation indicators and tests if CCII meets these criteria.

Part I - Constructing an alternative core inflation indicator

CRISIL Research has computed an alternative indicator of core inflation CRISIL Core Inflation Indicator (CCII) - which will improve the accuracy of measuring underlying demand-side pressures on prices. CCII is computed using manufacturing prices in India's wholesale price index after excluding the 'base metals' category. It therefore allows for inclusion of all manufactured items (including food and metal products), prices of which are demand driven. In contrast, base metals prices are directly linked to international prices and hence prone to high volatility. Currently, the core inflation measure used by the RBI as one of the inputs for monetary policy decision making as well as communicating with the public is the non-food manufacturing inflation. Non-food manufacturing excludes raw and processed food and fuel prices from the WPI basket. The CCII captures demand-side pressures on prices better and is more stable than the existing core inflation measure. In terms of weight in WPI, CCII has a slightly higher weight of 55.9 per cent compared to 55.0 per cent weight of the non-food manufacturing index. Both the measures have moved in near-tandem since April 2010, and are currently showing a decline since December 2011 (Figure 1). However, during periods of adverse shocks to the global economy, CCII is less influenced by temporary shocks and therefore, is more stable. It is thus, a better indicator of persistent demand pressures in the Indian economy. For instance, during 2009-10, while the non-food manufacturing inflation measure suggested that core inflation had fallen to 0.2 per cent, CCII was still high at 4.2 per cent. Our calculations show that CCII had reached 6.0 per cent by December 2009 itself. RBI, however, had started raising policy interest rate only in March 2010 when, among other factors, non-food manufacturing inflation had started approaching 5.0 per cent. At the time, low levels of non-food manufacturing inflation, were largely a result of a collapse of international base metal prices in the aftermath of the global economic crisis. In hindsight, early anchoring of demand-side pressures could have helped tame down inflation pressures more effectively during 2010-11 and 2011-12. CCII indicates, monetary tightening likely to have been delayed, in hindsight CCII less vulnerable to temporary shocks, hence more stable Non-food manufacturing - the existing measure of core inflation in India CRISIL Core Inflation Indicator (CCII)

CRISIL Insight

Figure 1: CRISIL Core Inflation Indicator

%, y-o-y 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0
Jan-01 Jul-01 Jan-11 Jul-11 Jan-04 Jan-00 Jan-03 Jan-06 Jan-07 Jan-08 Jan-05 Jan-09 Feb-12 Jan-02 Jul-02 Jan-12 Jul-04 Jan10 Jul-00 Jul-03 Jul-06 Jul-07 Jul-08 Jul-05 Jul-09 Jul-10

RBIs preferred measure of core inflation -non-food manufacturing

CRISIL Core Inflation Indicator (CCII)

-2.0

Source: Ministry of Industry and Commerce, CRISIL Research

M o n e t a r y p o l i c y e ff e c t i v e n e s s dependent on reliable measurement of demand-side inflation

WPI inflation in India has remained high and above RBI's comfort zone of 5 per cent in the last 6 years. Given the persistence in inflation, it has become increasingly important for the RBI to enhance the effectiveness of policy actions and communicate its intent clearly to the public. Monetary policy aims to control inflation in the economy by ensuring that demand moves in line with supply. Monetary policy effectiveness therefore, depends crucially on reliable measurement of demand-side pressures on inflation. Such measurement should effectively eliminate the effects of transitory supply shocks, for instance, an oil price shock, which by itself, has less lasting impact on inflation. To meet these objectives the central bank computes a measure of core inflation for India which looks at non-food manufacturing inflation. A core inflation measure seeks to gauge demand-side pressures on inflation by removing the effects of transitory supply shocks which, unlike demandside factors do not generally require monetary policy response. Monetary policy actions work with a lag and hence accuracy in inflation projections is critical. A reliable core inflation indicator must therefore be forward-looking with reasonable degree of forecast accuracy. Since March 2010, the RBI has often referred to the non-food manufacturing measure, in several of its communications related to monetary policy decisions. This measure, therefore, is believed to have influenced monetary policy actions in recent years. Unlike the RBI's preferred core inflation measure, CCII includes processed food prices, but excludes the prices of base metals (ferrous and non-ferrous) from manufacturing inflation. CCII includes processed food and metal products to take into account the secondround of impact of supply shocks and it excludes base metal prices which are directly influenced by international prices. Both core measures exclude the prices of primary commodities and fuels which reflect the first-round impact of supply shocks.

Core inflation measure, believed to have influenced monetary policy actions in the past

Figure 1 reveals the disparities in the information that CCII and the non-food manufacturing inflation measure provide about demand-side pressures.
n

In 2009-10, following the global economic crisis, while prices of non-food manufacturing articles contracted during April-October 2009, CCII declined, but never fell below 2.4 per cent during this period. A sudden and sharp decline in international base metal prices during this period was responsible for an equally sharp decline in non-food manufacturing inflation in 2009-10. By December 2009, CCII had nearly touched 6.0 per cent, while non-food manufacturing inflation was still hovering around 2.5 per cent implying that the latter underestimated demand-side pressures. In recent years, while both measures of core inflation have moved in tandem, CCII has generally been lower (except in 2009-10), but more stable than non-food manufacturing index, even if we exclude the 200910 episode. A similar difference in two measures of inflation was witnessed in 2004-05, when prices of base metals witnessed a steep rise. In recent months, CCII has begun to decline since November 2011, a month earlier than the non-food manufacturing inflation measure, and has dropped more sharply thereafter. In January-Februrary 2012, CCII was lower at 5.5 per cent average as compared to non-food manufacturing inflation at 6.2 per cent. In 2012-13, we believe CCII would decline faster than non-food manufacturing inflation measure, barring another collapse of international metal prices. This reflects a sharper decline in demand pressures on inflation. Disparity in two core inflation measures, reflective of differences in movements of base metal and processed food prices

The disparity in the two measures reflects the difference in movement of prices of processed food and metals. Prices of processed food (included in CCII; excluded from non-food manufacturing measure) rose by over 13 per cent y-o-y in 2009-10. In contrast, prices of base metals (excluded from CCII; included in non-food manufacturing measure) fell by over 8 per cent in 200910, following the Lehman crisis. The possibility that demand-side pressures were relatively firm in 2009-10 has significant policy implications. It suggests that the monetary policy loosening post-October 2008 might have been sharper-than-warranted. Further, subsequent interest rate hikes should have started much earlier than March 2010. Had this happened, inflation rate during the last couple of years could have been lower. Overall WPI inflation, however, would have continued to hover above the RBI's threshold level as an expansionary fiscal policy (led by sharp rise in government consumption expenditure) reduced the effectiveness of monetary policy actions.

CRISIL Insight

Part II - Desirable properties of core inflation indicator: Does CCII measure up?
Computation of core inflation from CPI, exclusion of metal prices, and inclusion of processed foods - a global practice Across the world, several central banks (such as Bank of England, Reserve Bank of New Zealand and Riksbanken - central bank of Sweden) monitor core inflation through a variety of measures, which are typically constructed using sub-categories of CPI data and hence exclude metal prices. Most core inflation measures also tend to include processed foods (Table 1). These measures either permanently exclude highly volatile prices (exclusion methods) or exclude volatile components based on statistical results on a periodic basis (statistical methods). In India, an early attempt at estimation of core inflation was made by Mohanty, Rath and Ramaiah (2000). More recently, Durai, Sethu & Ramachandran (2007), and Raj & Misra (2011) have estimated several measures of core inflation for the country.

Table 1: Official Core Inflation Measures: Cross-Country Practices Core Inflation Targeting Countries Canada

CPIX that excludes 8 most volatile components like fruits, vegetables, gasoline, natural gas, fuel oil, mortgage interest costs, intercity transportation and tobacco products CPI excluding interest and indirect tax CPI excluding tax and energy CPI excluding interest charges Core CPI excludes fresh food and energy prices which include rice, flour, cereal products, vegetables, fruits, electricity charges, cooking gas, and gasoline

Sweden Norway New Zealand Thailand

Other countries with official core inflation measures Japan Peru United States Philippines Korea Columbia Spain Netherlands Portugal CPI excluding fresh food CPI excluding 9 volatile items like food, fruits and vegetables, urban transport CPI excluding food and energy CPI excluding rice corn fruits vegetables, LPG, Kerosene, Oil, Gasoline, Diesel CPI excluding non-grain agricultural products and petroleum products CPI excluding agricultural food, public services and transport CPI excluding energy and unprocessed food CPI excluding fruits, vegetables and energy CPI excluding energy and unprocessed food

Source: Raj, J. & Misra, S (2011) Measures of Core Inflation in India An Empirical Evaluation, RBI working paper No 16

Desirable properties of core inflation are:

1.Core inflation should be less volatile than overall inflation and should remove the impact of temporary shocks
Globally, core inflation is usually calculated on the basis of the CPI after eliminating certain food and energy products as their prices are highly volatile and vulnerable to temporary domestic or global shocks. Moreover, CPI, by construction, does not include base metal prices. In India, the RBI calculates core inflation on the basis of WPI. The central bank's preferred measure of core inflation excludes all food prices (raw and processed) and energy prices. This core measure used by the RBI has two drawbacks: a) It is prone to volatility: it includes base metals prices, directly linked to international price movements, which are influenced by temporary shocks. b) It is less useful for gauging future demand-side pressures: it excludes processed food prices (manufactured food). a) A good core inflation measure should exclude the impact of temporary movement in overall inflation. It should reveal that component of overall price change which is likely to persist for an extended period, and can be easily forecasted. Base metals prices do not meet this criterion as they are highly volatile and linked to international metal prices which are inturn influenced by temporary supply shocks (Figure 2). The CCII therefore, excludes this component in its calculation. Existing core inflation measure, prone to volatility and less useful for estimating future demand pressures

Figure 2: WPI-base metals inflation vis--vis international base metals inflation

International inflation in base metals: left axis 130.0 110.0 90.0 70.0 WPI-base metals inflation 25.0 20.0 15.0 10.0 5.0 0.0 5.0 10.0 15.0 20.0 Mar-06 Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11

%, y-o-y

30.0 10.0 -10.0 -30.0 -50.0 -70.0

Note: International base metal prices are calculated by taking simple averages of inflation in base metal category commodities Source: CRISIL Research, Ministry of Industry

%, y-o-y

50.0

CRISIL Insight

For instance, in a recent RBI working paper on core measures of inflation in India, Raj & Misra (2011) noted that volatility in domestic metal prices increased in the 2000s vis--vis the 1990s, reflecting strong correlation with global metal prices. Volatility in domestic prices of metals such as iron and steel has been particularly high in recent years.

Table 2: Base metals and metal products inflation Base metals Mean Volatility (standard deviation) 7.3 8.5 Metal products Mean Volatility (standard deviation) 3.9 5.3

FY96-05 FY06-12

7.0 6.1

2.6 10.2

Note: Data till February 2012 Source: Ministry of Industry and Commerce, CRISIL Research

Exclusion of base metals from core inflation reduces volatility and impact of temporary supply shocks

Prices of metal products, in contrast, mirror the second-round impact of changes in the base metal prices, and thus, act as an indicator of demand pressures in the economy (Table 2). During FY96-FY05, when economic growth was relatively low, metal products inflation was at 2.6 per cent as compared with base metals inflation of 7 per cent. But during a relatively highgrowth phase of FY06-FY12, despite lower base metals inflation, at 6.1 per cent, metal products inflation shot up significantly to 10.2 per cent.

Table 3 WPI and Core Inflation Measures (April 2005 to February 2012) Weight Mean Standard Deviation Coefficient of Variation Volatility around Trend (annual) 1.1

Headline WPI Non-food manufacturing

100.0

6.6

3.0

8.8

55.0 55.9

4.7

2.7

7.2

1.3

CCII

4.7

1.5

2.4

1.0

Source: Ministry of Industry and Commerce, CRISIL Research

Going forward, global metal prices are likely to remain volatile since price contracts of iron ore and other metals have been converted into quarterly from annual contracts. If, in future, the contracts are moved to the monthly basis, it would bring further volatility to the measure of non-food manufacturing inflation which includes base metals prices. In addition, domestic metal prices are also influenced by temporary fluctuations in the value of rupee, which we believe will remain weak atleast during 2012-13 vis--vis the dollar. Based on this evidence, we believe, while metal products prices should be included in a measure of core inflation, base metals prices should be excluded - as is the international practice - to reduce volatility and temporary fluctuations. b) A measure of core inflation should not only eliminate volatility, but should also be able to gauge demand pressures. The exclusion of processed food prices from non-food manufacturing inflation, the RBI's preferred core inflation measure, defeats this purpose. Primary food inflation has become persistent in nature at 10.7 per cent average in the April 2005 to January 2012 period. This structural shift in primary food inflation, backed by strong demand has yielded into secondround impact on manufactured food inflation (Table 4), which remained elevated even during 2009-10 when non-food manufacturing inflation declined sharply (Figure 3). This makes it important to include the manufactured food prices in core inflation measure to aptly gauge demandside pressures. Going ahead, if global food prices continue to trend upwards due to persistent demand pressure, high food inflation may no longer be a temporary phenomenon. Prices of processed food also provide information about future inflation. Producers of processed food tend to change their prices infrequently, even though their production costs fluctuate frequently. Knowing that their next price adjustment may take some weeks or months, such producers need to be forward-looking when setting prices. If they perceive a temporary jump in the prices of their inputs - basic food, they may not fully pass on the higher input cost into their price. If however, they see a more permanent increase in prices of their inputs and a commensurate increase in demand for their products, they may increase the price of their products. Movements in prices for these sorts of items thus provide information about future price developments. In sum, we believe processed food prices should not be excluded from a measure of core inflation for India. Inclusion of processed foods in the core inflation measure allows for more accurate estimation of demand-side pressures on manufactured inflation

CRISIL Insight

Figure 3 Inflation in manufactured food and non-food manufacturing

%, y-o-y 20.0 Manufactured food Non - food manufacturing inflation

15.0

10.0

5.0

0.0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4* 5.0 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

Note: *Data for Q4 2011-12 is only for January-February 2012 Source: Ministry of Industry and Commerce, CRISIL Research

Table 4: Primary and manufactured food inflation Primary food articles Mean Volatility (standard deviation) 4.9 5.2 Manufactured food products Mean Volatility (standard deviation) 4.6 4.4

FY96-05 FY06-12

5.3 10.0

4.5 6.2

Note: Data till February 2012 Source: Ministry of Industry and Commerce, CRISIL Research

Figure 4: GDP deflator inflation and core inflation measures

%, y-o-y 12 10 8 6 4 2

GDP Deflator

2011-12*

2001-02

2003-04

2002-03

2005-06

2006-07

2007-08

CRISIL Core Inflation Indicator

Source: Ministry of Industry and Commerce, CRISIL Research

2004-05

2008-09

2009-10

Non food manufacturing inflation

10

2011-12*

2000-01

2010-11

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

2010-11

2.Core inflation measure should be able to predict future trends in overall inflation
Since monetary policy changes influence inflation with a lag, policy actions are largely based on forecast of inflation. It is therefore, critical that core inflation be able to predict future inflation with reasonable accuracy. The most comprehensive measure of inflation in a country is a percentage change in GDP deflator. CCII tracks overall inflation in the economy as reflected in GDP deflator better than the non-food manufacturing inflation (Figure 4). Since the beginning of the last decade, inflation as measured by changes in GDP deflator has moved directionally in line with CCII. Based on quarterly data since 2005-06, while the correlation between changes in GDP deflator and CCII is around 0.79 for, it is only 0.52 for changes in GDP deflator and the non-food manufacturing inflation measure. Preliminary statistical exercise reveals high correlation of both measures of core inflation with WPI inflation of around 0.82 between April 2005 and February 2012. Although the overall correlation between the two measures of core inflation with WPI inflation is similar, the ratio of WPI inflation to CCII however is relatively stable implying that during volatile period, CCII is a better gauge for underlying inflationary trends. To serve as an indicator for future headline inflation, core inflation measure should be able to forecast its own future trends. A preliminary exercise suggests that core inflation projections based on the ARIMA1 forecasting method for CCII are significantly better than that for the non-food manufacturing inflation measure. The forecast errors (% difference between forecast and actual values) are significantly smaller (Table 5) than for the nonfood manufacturing inflation. This means that CCII has higher forecast accuracy. Current data for CCII has better predictive abilities than non-food manufacturing measure. Forecast errors, are also largely unidirectional with the actual values being higher than the forecast except in 2010-11 which makes it easier to make out-of-model adjustments, if necessary, in the forecast of CCII. Once the forecasts for core inflation are generated, information based on assumptions for the balance components of WPI inflation (viz. primary articles, fuel and base metals) can be included to arrive at a forecast for overall inflation. CCII has higher forecast accuracy Inflation forecasts, critical for policy actions

ARIMA Autoregressive Integrated Moving Average models describe the current behavior of a variable in terms of linear relationships with their past values. While the basic ARIMA models do not incorporate future information, it is the most general form of modeling a time series which displays high persistence.

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Table 5: Comparison of actual v/s ARIMA out of sample forecast Non-metal manufacturing Forecast 2008-09 2009-10 2010-11 2011-12 2012-13 5.0 3.6 5.5 6.2 4.0 Actual 5.2 4.2 5.3 7.1* Non-food manufacturing Forecast 6.6 1.6 4.7 9.9 5.3 Actual 5.7 0.2 6.1 7.5* -

Note: *Data till February 2012 Source: Ministry of Industry and Commerce, CRISIL Research

Concluding Remarks
There is no single ideal measure of core inflation which would necessarily outperform all other measures across all time periods. Hence, it is better to judge inflation pressures on the basis of different measures which together provide a coherent picture of overall inflation dynamics. According to our analysis, of the two measures of core inflation non-food manufacturing and CRISIL Core Inflation Indicator the latter is less prone to supply-side shocks and is therefore less volatile. CCII also allows for better understanding of underlying demand pressures on inflation, and has better predictive abilities. CCII can therefore be an appropriate tool for policymakers to take effective monetary policy decisions.

References:
Durai, S., Raja Sethu, and M. Ramachandran. "Core Inflation for India." Journal of Asian Economics 18(2), April 2007: 365-383. Mohanthy, D., D.P. Rath, and M. Ramaiah. "Measures of Core Inflation for India. Economic and Political Weekly, January 2000: 273-283. Raj, J. and S. Misra. "Measures of Core Inflation in India - An Empirical Evaluation. 2011: RBI Working Paper No.16. 2011.

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