Explainer: What is inflation and how it is measured?

India's retail inflation saw a sharp rise to 6.95% in March, at 17 month high compared to 6.07% in February over higher food prices, the data released by the Ministry of Statistics and Programme Implementation showed. The CPI inflation during the corresponding period last year stood at 4.29%.

But what exactly is inflation, how is it measured, and how is it calculated? We explain everything you need to know about WPI and CPI in this story.

What is Inflation?

Inflation is the rate at which prices rise over a specific time period. Inflation is often defined as a broad metric, such as the overall increase in prices or the cost of living in a country.

For example, if the rate of rice a year ago was ₹100 a kilo and currently it is ₹110 a kilo, the inflation in the rice prices would be at 10 percent.

Inflationary pressures also reduce the buying power of investments. In other words, when you need to use the money you invested, it will be worthless. That is why it is critical to focus on investments that will generate a higher rate of return than the value of inflation.

Inflation rates are measured both year over year — how prices have changed over the last year — and month over month — how prices have changed over the past month.

How Inflation is Measured?

There are two measures of inflation in India, the Wholesale Price Index (WPI) and the Consumer Price Index (CPI).

To measure the average consumer’s cost of living, RBI conducts Households’ Inflation Expectations Survey to identify a basket of commonly purchased items and track them over time.

The consumer price index (CPI) is the cost of this basket at a given time expressed relative to a base year, and consumer price inflation is the percentage change in the CPI over a given period. This basket of products and services shows the consumer's cost of living at a specific level of income and prices.

On the other hand, the goods or services sold by businesses to smaller businesses for further sale are captured by the WPI. In India, both WPI (wholesale price index) and CPI (consumer price index) are used to measure inflation.

Policymakers also keep an eye on core consumer inflation, which focuses on the underlying and persistent trends in inflation by eliminating government-set prices and the more volatile prices of things like food and energy, which are most affected by seasonal factors or temporary supply shortages.

How does CPI work?

CPI is now calculated in India using a basket of 299 commodities. CPI is computed by taking the average weighted value of each item in the basket and multiplying it by the change in retail prices of goods and services.

The Ministry of Statistics and Programme Implementation (MOSPI) calculates the CPI for the country as a whole and for individual states.

CPI = (Cost of the market basket in a given year / Cost of the market basket in the base year) x 100

How does WPI work?

While retail inflation looks at the price at which the consumer buys the product, WPI is measured based on prices at the wholesale level.

It takes a basket of 697 items into account and shows the combined prices.

The basket used in WPI is composed of three groups: Manufactured Products (65 percent of total weight), Primary Articles like food, etc. (20.1 percent), and Fuel and Power (14.9 percent). The WPI is calculated by the Ministry of Commerce and Industry.

This inflation rate is often known as headline inflation. WPI is released by the Ministry of Commerce and Industry.

In 2013, the Consumer Price Index (CPI) replaced the Whole Sale Price Index (WPI) as the primary gauge of inflation in India. The Urjit Patel Committee advocated abolishing WPI and replacing it with CPI in India, which accurately reflects the difficulties encountered by consumers as a result of inflation. The Reserve Bank of India (RBI) has mandated using CPI as the sole indicator of inflation for its monetary policy.

Is the Inflation Index outdated?

The CPI basket will largely be kept constant throughout time for stability, but it is occasionally changed to reflect changing consumption patterns, such as including new hi-tech goods and replacing items that are no longer extensively purchased. Because it demonstrates how, on average, prices for all goods produced in an economy alter over time.

After its launch in 2010, the CPI was only modified once (with a base year of 2012). (the first monthly CPI inflation rate was announced in January 2011). Previously, the government measured retail inflation for just certain groups of the population (such as industrial workers and agricultural and rural labourers).

“There is no doubt that the current CPI (consumer price index) basket is outdated,” Pronab Sen, former chief statistician who also headed the National Statistical Commission (NSC) when the CPI was last revised, told Financial Express.

The current WPI base year is a decade old now. The story is the same for the Consumer Price Index (CPI), which measures retail inflation, and is a policy anchor for the Reserve Bank of India’s Monetary Policy Committee, he added.

“If you have a situation where a commodity group, whose weight has gone up, has higher inflation, it could push inflation up and vice versa. It will change the inflation trajectory to make it far more accurate,” he said.

The revisions in the base year are “necessary and in fact essential” to capture the structural changes in the economy, Sen said. “The old base will not pick up the current structure, therefore the estimate of inflation will be biased.”

The Department for Promotion of Industry and Internal Trade (DPIIT) had in June floated a draft technical report of a working group, which recommended revising the WPI base year to 2017-18 and proposed the addition of about 480 new items in the new series. With this, the WPI basket, which currently has 697 items, would have 1,176 items.