The key issue here is how core inflation is measured. The overall CPI gives us headline inflation—an average across everything in the consumer basket. But ever since the oil price hike of 1973, it is also thought prudent to look at a subset of that basket, after excluding two classes of goods that are internationally traded, and subject to globally-driven supply volatility on account of weather (food) or cartels (fuel). The residual is called ‘core’ inflation, which captures the inflation-generating dynamic in the domestic economic system.
Headline and core inflation are not unrelated. Rising food prices (as for instance currently in October on account of weather vagaries) could lead to rising wage demands and therefore drive up the core. These relationships are not stable or predictable. At any point in time, however, headline and core are separate measures that do convey useful information.
The standard measure of core inflation in India removes two sub-groups: food and beverages (with a weight of 45.86%), and fuel and light (weight of 6.84%). That leaves the core with a residual weight of 47.3%. The weight of the core can be further ramped up by reducing the food sub-group, but I will deal with that at the end.
Of material consequence is what goes into the fuel and light sub-group. Its item-wise components include fuel only as used for cooking and lighting (gas, kerosene). It does not include conveyance fuel (petrol, diesel), which therefore goes into the core, through the transport section of the miscellaneous sub-group. The core, rightly calculated, should have excluded petrol and diesel. Until calendar 2021, international fuel prices were benign. Once international oil prices started shooting up, recalculating the core was not something I could really postpone doing.
Over the four months June to September 2021, petrol inflation averaged 23.63% y-o-y, and diesel inflation averaged 23.98%. The average over the same months in 2019 stood at -8.08% for petrol and -5.78% for diesel. These are wild swings, and the very reason why the push towards measuring core inflation shorn of these volatile products gained global popularity in the first place. Yes, there is a large tax element in the prices of petrol and diesel, but the point is that these gyrations reflect what happened to the international price of oil, without any compensating reduction in domestic taxes.
The Reserve Bank of India has taken cognizance of this, and the last two monetary policy reports for April and October have provided alternative estimates of core inflation after excluding petrol and diesel from the core. However, there are some elements which should be added to the core at the same time, and one such is electricity (from the fuel and light sub-group). Unlike more developed countries, where the price of electricity is free to vary with the price of whichever fuel it is generated from, and is therefore in principle as volatile, power prices in India are regulated and hold steady for long periods.
Over June to September 2021 when international fuel prices were on the boil as shown above, electricity price inflation averaged 3.38 % y-o-y. Over May to September 2019, the corresponding average for electricity was -0.06 %, when petrol and diesel were declining much more sharply. Of course, what is measured in the CPI is electricity bought through the grid. Small-scale diesel generated electricity, an alternative used by assorted small enterprises when grid supply fails, would reflect the price of diesel in the core, but to weed that out takes a more complicated estimation procedure.
The core, excluding direct consumption of petrol and diesel, and including electricity, carries a weight of 46.35%, as against the unadjusted weight of 47.3 %. So adjusted, core inflation for September 2021 stands at 5.12 % (versus 5.89 % unadjusted), and has held steady at an average of 5.09% over June to September.
Finally, the official CPI is accompanied by a consumer food price index (CFPI), which excludes prepared foods from the food sub-sector. If we include prepared foods in the core along with the fuel adjustments detailed above, its weight becomes 53.15%, and core inflation in September 2021 goes up to 5.37%—and it has been steady around there for four months. It is higher because prepared foods currently run at inflation rates nearing the 7% mark, reflecting both the closure of small-scale units, which dominate the sector, as also the cost-push impact of diesel-generated electricity instead of power sourced from the grid.
Improved grid supply through power sector reform, and activating small scale units holds the key to bringing down core inflation, and will re-employ the skilled workforce previously employed in those units.
As for the non-core, inflation in oil and primary commodities is likely to persist for some time, on account of shortages in shipping containers and a number of other global supply-side disruptions.
Indira Rajaraman is an economist
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