Mixed Messages: Why Wholesale And Retail Inflation Are Diverging

The divergence in CPI-WPI may have something to do with index construction. But does that explain all of it?

<div class="paragraphs"><p>Vehicles travel along a near deserted road during a lockdown imposed due to the coronavirus in this aerial photograph taken in New Delhi, India, on Saturday, March 28, 2020.  Photographer: Anindito Mukherjee/Bloomberg</p></div>
Vehicles travel along a near deserted road during a lockdown imposed due to the coronavirus in this aerial photograph taken in New Delhi, India, on Saturday, March 28, 2020. Photographer: Anindito Mukherjee/Bloomberg

Wholesale inflation, measured by the wholesale price index, rose to the highest since 1991 hitting 14.2% in November. Retail inflation, measured by the consumer price index, in contrast, is at a more acceptable level of 4.9%.

Not only are the levels of inflation indicated by the two indices widely different, their directions have diverged too. While WPI inflation has risen sharply since the middle of this year, retail inflation has been range-bound.

What explains this?

Is It Just The Index Composition?

Often such a divergence is blamed on the composition of these indices. Both have different constituents and varying weight assigned to them.

The CPI basket is a reflection of the buying behaviour of consumers. Consumption patterns have been determined using the Consumer Expenditure Survey of 2011-12 and, based on that, weights are assigned to different items, according to a manual on CPI by the Ministry of Statistics.

For WPI, weights are assigned based on the share of the respective items in total wholesale transactions in the economy, according to WPI methodology published by the Ministry of Commerce.

The biggest difference is in the food category.

While food accounts for nearly half of the CPI basket, it accounts for a fourth of the WPI basket. Even within the food category, there is a wide difference in weights.

For instance, in the CPI basket, cereals have the highest weight at 9.7% of the total basket. Milk and vegetables are the second- and third-largest components at 6.6% and 6%, according to the Ministry of Statistics and Programme Implementation. In comparison, in the WPI basket, milk has the maximum weight at 4.4%, followed by cereals and vegetables at 2.8% and 1.9% respectively, according to the Ministry of Commerce and Industry.

Another difference between CPI and WPI is services.

The 'miscellaneous' category in CPI, which makes up about a fourth of the index, includes services like education, health, recreation, and goods such as gold jewellery. These are not included in WPI.

WPI, in turn, includes commodities such as minerals, which are not there in CPI. Nearly 60% of WPI consists of either non-food manufactured products or commodities.

There are differences in the way the indices are compiled too.

Price collections for CPI are done from local outlets. Data is collected from 1,114 urban markets and 1,181 villages. The selection is based on identification of popular markets and shops. Data for WPI is sourced once every month from a survey of different private and public sector units producing those goods. Price quotations are collected through online surveys.

Do Demand Conditions Play A Role In The Divergence?

The construction of the indices only goes so far in explaining the divergence in retail and wholesale inflation. There are often other reasons for a wide divergence emerging between CPI and WPI, which has happened in the past too.

There have been divergences between WPI and CPI, but this extent of divergence is unusual, said Pronab Sen, former chief statistician of India.

The divergence is too large to put it down to just weightages of constituents in both indices. The divergence reflects that different parts of the economy are seeing a revival at different paces.
Pronab Sen, Former Chief Statistician of India

The CPI contains finished goods whereas WPI contains primary and intermediate goods. This is where the big difference is coming from, Sen said. Production has caught up with pre-pandemic levels, but consumption is still below those levels.

While those in the earlier stages of production are raising prices, consumption in final stages is still very weak, weighing down final prices.
Pronab Sen, Former Chief Statistician Of India

Food, Fuel Volatility Key Sources Of Divergence

Food and fuel are the two components where the divergence is most stark.

The vegetable and fuel sub-indices in WPI have risen significantly over a six-month period, with a sharp spike in November. Retail prices in these categories also rose but not by as much.

The divergence on wholesale and retail prices of vegetables has confounded economists. Typically, these move together, said economist Abhijit Sen.

Explaining the divergence on fuel, Abhishek Upadhyay, senior economist at ICICI Securities Primary Dealership, said international crude prices had surged in October and the rise is showing with a lag in WPI. CPI, on the other hand, is reflecting a cut in excise duties, which brought down retail prices of fuel.

Upadhyay said the divergence is not as acute when you look at core WPI and core CPI. Core inflation indices strip out volatile items like food and fuel. This indicates that the rise in headline WPI is largely led by food, primarily vegetables, and fuel. This partly explains the large gap between both indices, Upadhyay said.

Moreover, the divergence between core measures is even smaller if one looks at core goods CPI that is far more elevated than core CPI, Upadhyay said.

Core goods CPI was high at 7.7% in November, compared to core WPI of 12.3%. Meanwhile, core services CPI was at 4.3% in November, helping rein in headline retail inflation, he said.

Will CPI Converge To WPI Or Vice Versa?

The divergence between wholesale and retail inflation has a bearing on policy decisions. Monetary policy has so far remained accommodative as retail inflation has been within the central bank's target of 4 (+/-2%). CPI inflation is the nominal anchor for monetary policy in India.

However, if WPI inflation were to finally feed into CPI inflation, monetary policy may need to be tightened.

Vivek Kumar, economist at QuantEco Research, said some degree of pass-through from WPI to CPI is inevitable. The persistence of core WPI inflation at record high levels reflects pressure from input prices. Adjusted for the difference in index construction, this would continue to impart upside pressure to core CPI inflation, Kumar said.

However, historically, the correlation between the two indices is far from perfect, he warned. This makes it hard to determine how much the pass-through will be this time around.

The actual pass-through is usually a function of the business cycle. Despite the anticipated V-shaped recovery in FY22, the economy faces a wide negative output gap, which would dampen the extent of transmission.
Vivek Kumar, Economist, QuantEco Research

Sen shares a similar view.

WPI is taken to be a leading index and CPI should follow WPI, Sen said. "Whether it converges or not depends on what happens to demand and if that picks up," said Sen. "If it does then producers can pass on the rise in price to consumers."