India Needs A Cost-of-Living Index To Reflect People’s Inflation Experiences

Chennai: While Consumer Price Index numbers have remained moderate, the cost of essential commodities, education, healthcare and other services have seen significant rises. Rajni Thakur, chief economist, L&T Finance finds that the inflation experience of different households is quite different from the headline numbers. This makes a case for two indices - one for tracking the cost of living and another for tracking an aggregate index for policy purposes.

We are seeing sharp price increases in onion, sugar and other essential commodities. Education costs have been rising year after year. Costs of healthcare, rent, insurance and other services are also rising. However, when we look at CPI inflation, it is relatively moderate. Why is there such a gap between official CPI numbers and people's experience?

It is a very pertinent question because it is important to step back and understand what CPI is meant to serve and whether we should expect people's individual experience of the cost of living to be reflected in the CPI.

The Consumer Price Index is essentially an average for all India and across different consumption baskets. It captures changes in prices month on month. Household consumption surveys broadly tell us how much is spent, or what percentage of household expenditure goes towards a particular item. The month-on-month changes in those prices are captured and indexed to give us the CPI.

But consumption patterns change over time. We might have had very heavy telecom bills at one point, while telecom bills have come down significantly in recent years. There are also commodities such as sugar that can become very expensive and then see prices normalize within a few months. Some items get included, some get excluded, and some experience temporary price increases. At the same time, expenses such as medical and education costs can remain elevated for longer periods.

So does this mean the consumption basket itself needs to change as the economy evolves?

Absolutely. As the economy grows and matures, the allocation of household expenditure across different items changes. For example, food accounted for more than 50% of household consumption a couple of decades ago in both rural and urban areas. Now it is down to around 36% and 47%, respectively.

So, at a particular point, a household may feel that onion prices are extremely high, and that experience certainly has a bearing on its cost of living. But at an aggregate level, food constitutes a smaller share of total household consumption today. Therefore, a rise in onion prices may not have the same impact on the overall CPI as it would have had when food accounted for a much larger share of household expenditure.

At the same time, the latest consumer expenditure survey shows that education, rent, healthcare and out-of-pocket healthcare expenditure constitute a material proportion of household spending. Consumption patterns are structurally changing. Even within food, cereals are becoming less important in the consumption basket, while beverages and packaged food are gaining weight.

Education has a weight of 3.3% in the CPI, while healthcare has a weight of 6.1%. Considering India's young population and the amount families spend on education and healthcare, are these weights adequate?

The one-word answer is yes, because there is a statistical method of arriving at these weights. CPI weights are an aggregate across states and cities. There is a large part of the population that may be retired or may not have significant education expenditure. There are also different age groups and different income groups with very different spending patterns.

Education expenditure in a metro city can be very different from that in a tier-two or tier-three town. Similarly, younger families in the 30-50 age group may spend much more on education than older households.

So, at an aggregate level, the CPI is a statistical expression and works well for what it is supposed to do — give us a signal of how prices are moving. But it does not necessarily reflect the spending pattern or the inflation experience of a particular age group, income group or household.

How frequently should India's CPI weights be revised? Is a five-year cycle adequate when consumption patterns are changing so rapidly?

There are different views among economists. Economies such as the US revise their weights every year. The UK does it more frequently, while the Netherlands is trying to use data as frequently as possible. India, along with many other developing economies, follows a five-year pattern.

There are pros and cons. A price index provides a signal for many policy decisions. If wage contracts are negotiated on the basis of price trends, the index needs to be relatively stable. Similarly, minimum wages need a stable reference rather than moving sharply because onion prices rise one month and then fall after seasonal conditions normalize.

The same applies to buffer stocks. If pulses become expensive and the government needs to replenish its buffer, policymakers need a stable index to understand the broader price trend. Fiscal policy, taxes, subsidies and direct benefits also require a relatively stable number to provide a clear direction.

So there is a trade-off between capturing the latest consumption basket and providing a stable basis for policymaking.

But consumption preferences are changing rapidly. Doesn't a five-year revision create a risk that the CPI becomes outdated?

That is a valid concern. Consumption preferences can change frequently, so there is a risk of obsolescence. One could consider whether the revision frequency should move from five years to two or three years if the economy reaches a point where consumption patterns are changing that quickly.

But more frequent surveys also involve administrative costs. For the current Indian economy, five years is still a reasonably stable period to work around.

Countries such as the UK, Netherlands and Australia are increasingly using scanner data and online prices. What can India learn from these approaches?

That is certainly an aspirational model. Countries are increasingly able to aggregate information from retail and e-commerce platforms to understand consumption behaviour.

India can eventually move in that direction, but we are not ready yet. Retail and e-commerce platforms currently account for only a portion of total consumption expenditure. A significant amount of consumption still happens through neighbourhood markets and traditional retail channels.

When 80% or 90% of consumption is happening through retail or e-commerce platforms, it will become much easier to use that information to track consumer expenditure and consumption patterns. At present, relying only on such data would provide a partial signal.

Can a single CPI number realistically represent the inflation experienced by a rural labourer, a middle-class family with children and a retired household?

In short, no. It is not meant to. CPI gives us an aggregate measure of the consumption, expenditure or inflation experience of different households and averages that into a single number.

But the expenditure pattern of a retired household will be very different from that of a young family or a student. Their composition of expenditure and the amount they spend on different items will vary significantly.

Ideally, there should be a separate index for tracking the cost of living alongside CPI, which would continue to serve as an aggregate index for policy purposes. There is a strong case for India to consider this.

Should India introduce a household cost-of-living index that shows how inflation affects different income groups and locations?

Definitely. We already have state-wise inflation data and disaggregated rural and urban inflation data, and there is significant variation across states.

We could begin with state-wise cost-of-living indices or identify major cities where such an index would provide a good representation of how the cost of living is evolving.

As India moves towards more federal and local-unit governance, a city- or state-wise cost-of-living index could help governments make more effective localized policy decisions.

How would more disaggregated inflation data help monetary policy? Could it help the RBI distinguish supply-driven inflation from demand-driven inflation and avoid unnecessary rate hikes?

That would be one of the biggest benefits. A more disaggregated index could distinguish volatile components of inflation from more stable components.

We already see periods when vegetable or edible oil prices rise sharply and then cool down. If monetary policy reacts strongly to such temporary volatility, there is a risk of overreaction.

A cost-of-living index that captures these changes more effectively could help policymakers distinguish between volatile and non-volatile components when taking interest-rate decisions.

What difference would such segregated data make to an ordinary household?

It could make a significant difference. Consider a professional choosing between a job in Delhi and one in Bengaluru. A better understanding of the cost of living in different locations would tell that person what standard of living a particular salary can provide.

For policymakers, it could show, for example, that medical expenses are rising rapidly in a particular state or city and help determine whether healthcare outreach needs to be expanded there.

So this kind of data can help supply-side policy, monetary policy and fiscal policy, while also allowing individuals to make better-informed decisions about where they live and work.

What other changes would make India's inflation data more robust?

One possibility is more frequent revisions. We could examine whether a two-year or three-year cycle would reduce the fear of the consumption basket becoming obsolete.

But more importantly, India could consider two series: one for tracking the cost of living and understanding changing consumption patterns, and another aggregate index for policy decisions.

We already have the distinction between core and headline CPI. We could similarly have CPI and a cost-of-living index. That would be very helpful.

We have also recently started looking at producer-level and consumer-level price indices. As a time series develops, these can help us understand how much of the increase in production or input costs is being passed on to consumers across sectors. It can also help us measure demand and supply responses across different sectors.