Understatement of rate of inflation

The rate of inflation as measured by the Consumer Price Index (CPI) has been declining. It was 11.1 percent in April 2021. It then fell to 10.9 percent in May 2021, to 9.7 percent in June and now to 8.4 percent in July. This must be considered as a major positive development, especially since it has happened at a time when prices of major imported items have been rising rapidly during these months. This is reflected in the record level of monthly imports of $6.3 billion in June 2021 due largely to the higher price effect.

However, the fall in the rate of inflation according to the CPI is not visible in the WPI. The Wholesale Price Index (WPI) has actually shown a higher rate of increase since April 2021 when it was 16.6 percent. It now stands at 17.3 percent in July. Does this mean that retail margins are beginning to be squeezed?

Also, the price index of food, beverages and tobacco at the retail level has shown a relatively modest increase of 8 percent, while the rise at the wholesale level is almost twice at 15.6 percent. This tends to confirm the fall in retail margins. However, there is usually a lag in the transmission from wholesale to retail prices. As such, the CPI could again go back to higher inflation in food items.

There is similarly a divergence in the rates of inflation revealed by the CPI and SPI (Sensitive Price Index). Almost two-thirds of the weight in the SPI is of food items. If the food inflation is at 8 percent then, given that the SPI has increased by 16.2 percent, the prices of non-food items in the SPI have gone up by as much as 32.6 percent. This is highly unlikely.

The divergence of almost 9 percentage points in July among the three indices of inflation raises the likelihood that the rate of inflation according to the CPI may be somewhat understated. The objective of this article is to examine if this might be the case.

The first indication that there may be an understatement is in the rise in the tariff on electricity. Annexure-I to the Monthly Review of Price Indices has prices of items in 17 cities and towns of the country. The Annexure shows in Serial No.41 that the electricity charge has gone up from Rs 3.70 to Rs 5.96 per kwh, representing an increase of 61.08 percent. However, in Annexure-A and Annexure-B, for urban and rural consumers respectively, the increase in electricity charges is shown as much less at 21.72 percent. This alone implies a lower rate of inflation in the CPI for urban consumers of 1.8 percentage points and in the case of rural consumers by 1.1 percentage points. As such, this mistake by the Pakistan Bureau of Statistics (PBS) has led to an understatement of the national rate of inflation in the CPI in July 2021 of over 1.3 percentage points.

The second problem lies in the underreporting of the rate of inflation in housing rents for many months now. It is shown a just over 6.1 percent in July. It is even lower than the rise in the cost of construction inputs, which is reported at 9.8 percent.

The long-run tendency has been for housing rents to rise in real terms, that is, at a rate faster than the overall rate of inflation. Between 2012-13 and 2018-19, while the overall CPI went up by 37 percent, the house rent index rose by 49 percent. Also, the housing shortage is large at over 5 million housing units and growing rapidly because of the high rate of rural-urban migration, especially to the metropolitan cities. Clearly, PBS is reporting a significantly lower rate of inflation in rents than is likely to be case. If adjustment is made for this underreporting it will add almost another 1 percentage point to the rate of inflation in the CPI.

The third source of understatement is the ‘high base effect’. This is especially the case with prices of perishable food items like vegetables and fruits. Prices of these items were increasing by 16.9 percent in July 2020. They were unusually high. Consequently, in July 21, for this group of items, there is a fall in prices of 9.1 percent. In August 2020, the increase in prices of these items came down sharply to only 3.7 percent. Therefore, the month of August 21 may show some inflation in the prices of these items.

The other lagged effect is likely to be in the full reflection of much higher import prices on domestic prices. A good example is palm oil. The price in 2021 was already up by 38 percent according to the monthly commodity price statistics of the IMF. The price of vegetable ghee in the country is up by 22.3 percent in July. A similar impact may be seen in the case of garments and household textiles due to rising import price of cotton, which has approached 31.4 percent in July.

Finally, there is a problem with the methodology used to estimate the average price in the country in Annexure-1. Information on prices is collected from 17 cities and towns in the country. This is adequate for construction of the ‘urban’ rate of inflation. But how is the ‘rural’ rate of inflation constructed?

Further, the cities and towns range in population size from over 14 million in Karachi to less than 1 million in cities like Bannu and Larkana. As such the average price should be derived on the basis of the population weighted average of the 17 locations.

This approach was adopted to determine the rate of inflation in the milk price. This is the largest item in the price index after housing rent. For the largest cities the rate of inflation in the milk price was almost 14 percent, as compared to 9 percent in the smaller towns.

Overall, the rate of inflation according to the CPI appears to have been significantly understated in July 2021 at 8.4 percent. It is probably closer to 12 percent. Double-digit inflation continues in the country. There is no justification for any complacency that the high inflation problem has been largely solved.

(The writer is Professor Emeritus at BNU and former Federal Minister)

Copyright Business Recorder, 2021