"Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair." -- Sam Ewing.

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every rupee you own buys a smaller percentage of a good or service.

Types of inflation are –

Deflation is when the general level of prices is falling. This is the opposite of inflation.

Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!

Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.

Causes of inflation are -

Cost-push inflation: Occurs when there is supply side constraint. Supply side constraint may occur due to several reasons like low production, increase in input costs, international conflicts etc. Generally there is little a government can do to increase the supply.

Demand-pull inflation: Occurs when the demand increases significantly. The increase in demand is attributed to the fact that there is excess liquidity in the market and people have high purchasing power.

Built in inflation: Most of the time employees force the employers to increase their wages.Due to increase in the wages the cost of production increases. In order to minimize loss the manufacturer passes on the cost to the consumers resulting in increase in the prices. This further leads to demand for more wage hike. Thus the increase in wage is linked to increase in price and vice versa. It results in vicious cycle and the government faces lots of difficulty in getting out of it.

It's not India alone, where authorities are battling to keep growth on track while reining in price.Governments and policymakers across the world are confronting the same challenge on the back of a sustained spike in global commodity prices that is stoking inflationary expectations.

While India’s wholesale price-based inflation rate rose to a three-and-a-half-year high of 7.83 per cent per cent for the week-ended May 3, China's consumer price index, the main gauge of inflation, rose 8.5 percent year-on-year in April. Inflation has been a major concern in the European Union (EU) as well. The average forecast for 2008 inflation from experts taking part in the ECB's Survey of Professional Forecasters (SPF) rose to 3.0 per cent from 2.5 per cent.

Measuring Inflation – An Indian Perspective

India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. However, most developed countries use the Consumer Price Index (CPI) to calculate inflation.

Wholesale Price Index (WPI)

WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s.

WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy.

Consumer Price Index (CPI)

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation.

CPI is a fixed quantity price index and considered by some a cost of living index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.

The argument against WPI is that it does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level. The main problem with WPI calculation is that more than 100 out of the 435 commodities included in the Index have ceased to be important from the consumption point of view. Take, for example, a commodity like coarse grains that go into making of livestock feed. This commodity is insignificant, but continues to be considered while measuring inflation.

India constituted the last WPI series of commodities in 1993-94; but has not updated it till now that economists argue the Index has lost relevance and cannot be the barometer to calculate inflation.

WPI is supposed to measure impact of prices on business. But in India it is used to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index. And it does not factor in services which have assumed so much importance in the economy.

But then what stops India from shifting over to CPI? The problems it seems are many. First of all, in India, there are four different types of CPI indices, and that makes switching over to the Index from WPI fairly risky and unwieldy. The four CPI series are: CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural laborers; and CPI Rural labor. Secondly, the CPI cannot be used in India because there is too much of a lag in reporting CPI numbers. The WPI is published on a weekly basis and the CPI, on a monthly basis. And in India, inflation is calculated on a weekly basis.

Concerns for India

A high rate of inflation could have a significant bearing on Indian economy’s overall growth through lower aggregate demand of manufactured items and low investment growth. Besides, a fear of a possible recession in the USA could worsen matters further. Prime Minister’s Economic Advisory Council had projected an 8.5 per cent gross domestic product (GDP) growth for India in 2008-09. But now the growth could fall further as policy focus shifts from high growth to price control. After growing at a blistering 9.6 per cent in 2006-07, government’s own estimates said it grew by 8.7 per cent in 2007-08. The effect of the high rates of inflation on the India growth story would depend on how long the situation of high inflation persists. The pressure on inflation is likely to persist due to high crude oil prices.

What is driving inflation in the current scenario?

But why are prices rising? Is it because of oil? With prices of global crude oil crossing $120 per barrel, oil is definitely one of the drivers. But why should high oil prices increase the cost of pulses, or fruits, which are grown at home? After the recent revision of retail prices of petrol and diesel, which has more closely aligned domestic and international prices, there haven’t been any more changes in domestic petroleum prices. Then is it because people have suddenly started eating more pulses and fish? Well, pulses are not really close substitutes of rice and wheat. Irrespective of regions and incomes, they have been staple fodder for Indian households—rich or poor—down the ages. As far as fish is concerned, the outbreak of bird flu and panic culling of chickens might have seen a spurt in fish prices in West Bengal and some neighboring states. But again, that’s not a convincing explanation for increases in fruit and vegetable prices.

Rise in food prices in India is essentially a result of supply shortfalls. With demand unchanged, lower supply leads to lower availability and concomitant price increases. In times when supplies are fine, food prices do not contribute to inflation. On the primary goods front, which consists of fruits, vegetables, food-grains etc. it is not that straight-forward. Why the price rise in primary goods is not straight-forward is that while on the one hand, it is a clear case of demand-pull inflation, on the other, it is also a bit of a supply shock when one considers the fact that there is an abnormally high percentage of fruits and vegetables that goes to waste because of the lack of cold-storage facilities. Some estimates say 50 per cent of produce goes to waste and that is a conservative number. Other than food prices, inflation can pick up due to higher prices of oil as well as manufactured items. However, from a common man’s perspective, higher food prices make him most conscious about inflation since he starts feeling the pinch on almost a daily basis. This is precisely where the current bout of inflation has acquired a damaging dimension. It has been reported that the manufacturing capacity in India is running around 95 per cent, which usually means it is running at full capacity. Therefore, when the price of manufactured products is increasing, it means that demand is usually higher than supply and that is a clear case of demand-pull inflation.

The euphoria over 9% GDP growth has made many overlook the fact that most of North India didn’t get usual rainfall this winter. This might affect the rabi output. There are already reports of oilseeds production taking a hit and forcing customs duty cuts on a variety of edible oils for increasing imports. There will probably be more supply concerns for other crops also, if the overall rabi crop is much smaller this time around. On the oil front, global crude prices show no signs of relenting. Though with elections drawing closer, further pass-throughs are unlikely, the ‘imported’ pressure on domestic prices will continue to remain.

This brings us to manufacturing. Normally, policymakers do not tend to lose their sleep over some escalation in manufacturing prices. Good demand for manufacturing usually results harder prices. However, this time the situation is somewhat different. Domestic manufacturing is facing difficulties on account of high prices of imported raw materials, particularly metals. Sustained high input prices will, sooner or later, force producers to increase finished product prices. This is likely to unleash a chain effect of price rises throughout the economy as users of manufactured inputs also start raising their prices. Higher prices of auto parts leading to higher prices of passenger cars are a typical example. The worst-affected will be the average consumer. With high food prices hitting hard at home, the situation won’t much better outside with purchasables also becoming dearer.

In India, growth and prices usually tend to move together. Either they rise in tandem, or remain moderate. There is no doubt that high growth with low prices continues to remain the foremost objective of macroeconomic management. However, in a country where supply isn’t very fast in responding to changes in demand, flare-ups in prices are unavoidable. Thus high growth with moderate prices is hard to achieve on a sustained basis unless supply-side constraints are taken care of. The spread of organised retail, particularly food retail, can help by ensuring quick delivery of agri-produce to consumers. That might involve a greater participation of foreign retailers.

Government measures to control Inflation

We all know the phenomenal growth of Indian economy in the last few years. This growth has not come without its side-effects. One of the causes for the increase in the prices of essential commodities has been due to the fact that both India and China have been recording excellent growth in recent years. It has to be noted that China and India have a combined population of 2.5 billion people.

Given this size of population even a modest $100 increase in the per capita income of these two countries would translate into approximately $250 billion in additional demand for commodities. This has put an extraordinary highly demand on various commodities. Surely growth will come at a cost.

The excessive global liquidity has facilitated buoyant growth of money and credit in 2005-06 and 2006-07. For instance, the net accretion to the foreign exchange reserves aggregates to in excess of $50 billion (about Rs 225,000 crore) in 2006-07. Crucially, this incremental flow of foreign exchange into the country has resulted in increased credit flow by our banks. Naturally this is another fuel for growth and crucially, inflation.

The Indian Government has been trying hard to contain inflation as it also has a political dimension. It has tightened the money supply. In addition, it has raised the export duties on many basic commodities and at the same time, tried to encourage imports by reducing the import duties. It also has announced many subsidies and has vowed to break the cartel existing between cement and steel companies. In addition it is also taking measures to ban futures trading of essential commodities.

The Reserve Bank of India has adopted the strategy of dealing with excessive liquidity through the Market Stabilization Scheme (MSS). Similarly, the increase in repo rates (ostensibly to make credit overextension costly) and increase in CRR rates (to restrict excessive money supply) are policy interventions that have been undertaken by the RBI. But these policies are with serious limitations in the Indian context with huge forex inflows

It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but at least by holding on to it, so as to address growth concerns. Any tightening of monetary policy would have serious implications at a time when the investment climate is not at the pink of health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.

It also a timely reminder about the need to keep a low interest rate cushion when the economy is doing well, so that it gives the Government a sufficient enough interest rate buffer that it can exercise and increase rates when inflation rears its head.

For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In such circumstances, monetary policy will be more critical in lowering the cost of capital and encouraging growth, and will have only a minimal role in controlling inflation.

In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of the past few years, was taking its toll on an over-stretched economy and supply side constraints were becoming increasingly evident, a relative cooling off should even be welcomed.

Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth without stoking off inflation was impossibility. A slowdown in growth to 7-7.5% should suit us, in so far as it would help prevent over-heating and consequent build up of inflationary pressures, all of which have the potential of squeezing medium-term growth itself.