Understanding Inflation in India

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During the last decade, inflation has become a leading concern for India’s economic policymakers and citizens. Worries have grown as the inflation rate (measured as the 12-month change in the consumer price index) rose from 3.7% to 12.1% between 2001 and 2010. The inflation rate has since fallen, reaching 3.7% in February 2017, leading to a debate about whether it will rise again.

What explains the movements in India’s inflation rate?

• Economists, policymakers, and journalists have all proposed answers.
• Raghuram Rajan, the former governor of the Reserve Bank of India, feared that if high levels of inflation became embedded in the expectations of price-setters, it would create a self-sustaining inflationary spiral.
• Recent debates about inflation in India are reminiscent of the discussions about inflation in advanced economies in the 1970s and 1980s when inflation in the US and Europe reached double digits.
• These debates created a large body of research on inflation, especially in the US.
• The increases in food price inflation, especially for staples such as pulses, milk, fruits, and vegetables.
• Shifting dietary patterns, rising rural wages, government price supports and its rural un-employment guarantee scheme may also have driven these price increases.
• Some have suggested that the monetary and fiscal stimulus following the crisis led to higher inflation, while others cite supply-side constraints from policy bottlenecks.
• Despite differences between the Indian and US economies, the factors that drove inflation were similar in many respects.
• In our recent paper, we explore the distinction between the headline and core inflation, which is a fundamental issue in discussions of inflation (Ball et al. 2016).
• Core inflation captures the underlying trend, while headline inflation fluctuates around the core because of changes in the relative prices of goods – ‘supply shocks’.
• We follow the Federal Reserve Bank of Cleveland’s approach to measure core inflation by taking the weighted median of price changes across industries.
• To implement this approach for India, we examine the inflation rate in the wholesale price index (WPI).
• Given that WPI inflation is highly disaggregated by sector, we can compute a historical series for median inflation.