Producer Price Index (PPI): The Key to Understanding India’s Inflation Puzzle!

The Producer Price Index (PPI) in India, a critical economic indicator tracking price changes from the producer’s perspective, is set to replace the Wholesale Price Index (WPI) as the country aligns with G20 practices. This transition, currently under review by the National Statistical Commission, aims to provide a more accurate measure of inflation by including both goods and services, initially focusing on goods.

This topic of “Producer Price Index (PPI): The Key to Understanding India’s Inflation Puzzle!” is important from the perspective of the UPSC IAS Examination, which falls under General Studies Portion.

Introduction

• Definition of Producer Price Index (PPI)
  • The Producer Price Index (PPI) is an economic indicator that measures the average change over time in the selling prices received by domestic producers for their output. It tracks price movements from the perspective of the producer, excluding indirect taxes, and can be calculated at different stages of the production process, such as when goods leave the place of production (Output PPI) or enter the production process (Input PPI).
• Importance of PPI in Economic Analysis
  • The PPI is crucial for understanding inflation at the wholesale level, providing insights into price changes before they reach consumers. It helps policymakers, businesses, and economists predict future consumer price inflation and make informed decisions regarding monetary policy, contract adjustments, and business strategies. By tracking the prices producers receive, the PPI offers a clear picture of the economic environment and helps in assessing the health of various industries.

Historical Context

• Evolution of price indices in India
  • Introduction of Wholesale Price Index (WPI) during the Second World War
    • Records of WPI compilation available from early 20th century (1915)
    • WPI introduced as a ‘quick’ series during World War II using August 1939 as base
    • Regular publication of WPI started after 1947, initially as a weekly series
  • Transition from WPI to PPI in various countries
    • Most G20 countries, including China, have adopted PPI
    • India one of the few countries still using WPI
• Development of PPI in India
  • Initial discussions and meetings for PPI implementation
    • Idea of PPI first mooted around 20 years ago
    • Working group set up in 2014 to determine methodology and data requirements
    • Report submitted in 2017, but no decision taken
  • Role of the Office of Economic Adviser in PPI development
    • Responsible for compilation and publication of WPI
    • Involved in discussions and meetings for PPI implementation

Conceptual Framework

• Theoretical foundations of PPI
  • Economic theory and index number theory
    • The PPI draws from economic theory of production and short-term rigidities in the production process
    • It is based on index number theory, similar to the Consumer Price Index (CPI)
  • Differences between PPI, CPI, and WPI
    • PPI measures price changes from the producer’s perspective, while CPI measures from the consumer’s perspective
    • PPI excludes indirect taxes, while CPI includes them
    • PPI covers only goods, while CPI covers both goods and services
    • WPI is a narrower measure focused on wholesale prices, while PPI is a broader measure of producer prices
• Types of PPI
  • Output PPI vs. Input PPI

Output PPI	Input PPI
Measures prices when goods leave the place of production	Measures prices when goods enter the production process

• Industry-level, commodity classification, and final demand-intermediate demand indexes

Industry-level	Commodity Classification	Final Demand-Intermediate Demand
Measures price changes received by industries for their output	Groups output based on product nature or end-use	Measures price changes based on the buyer’s economic identity and whether goods require further processing
Over 500 industry categories	Over 3,800 commodity price indexes for goods and 900 for services	Over 600 indexes, including final demand (consumption, investment, government, exports) and intermediate demand (inputs to production)

Methodology

• Calculation of PPI
  • Formula: PPI
    • The Producer Price Index (PPI) is calculated using the formula:

• This formula measures the average change in selling prices received by domestic producers for their output over time.

• Data collection and sources
  • Data for PPI is collected from a variety of sources, including surveys of producers, administrative records, and transaction prices.
  • In the UK, for example, data is collected via statutory monthly surveys and supplemented with administrative data from various government departments and industry sources.
  • In Australia, the Australian Bureau of Statistics (ABS) collects data from industries such as mining, manufacturing, construction, and services.
• Weighting and sampling techniques
  • Weights are assigned to different items based on their economic significance, which improves the precision of PPI estimates.
  • The weights are typically derived from National Accounts Input-Output tables and are updated periodically to reflect changes in the economy.
  • Sampling involves selecting representative establishments and products within each industry to ensure comprehensive coverage and accurate measurement of price changes.
• International best practices and models
  • Australian model
    • The ABS uses a comprehensive set of producer price indexes covering various sectors, including mining, manufacturing, construction, and services.
    • The indexes are updated in line with the Australian National Accounts Input-Output tables, ensuring they reflect current economic conditions.
  • UK model
    • The Office for National Statistics (ONS) in the UK follows international best practices by using annual rebasing and chain-linking methods to keep the PPI relevant and comparable over time.
    • The ONS also uses a combination of survey data and administrative records to compile the PPI, ensuring high accuracy and reliability.
  • New Zealand model
    • Statistics New Zealand publishes quarterly PPI data, which measures changes in the prices received by businesses for their goods and services.
    • The PPI covers various sectors, including primary products, manufactured goods, and services, and uses a methodology similar to that of Australia and the UK to ensure consistency and comparability.

Implementation in India

• Steps taken for PPI implementation
  • Formation of working groups and core groups
    • The Government set up a Working Group under the Chairmanship of Professor B.N. Goldar on August 21, 2014, to suggest the methodology for introducing the Producer Price Index (PPI) in India.
    • The Working Group submitted its report on August 31, 2017, outlining recommendations for PPI implementation.
  • Meetings and discussions on methodological issues
    • The first meeting of the Working Group was held on September 18, 2014, to discuss the broad objectives and methodological aspects of PPI implementation.
    • Subsequent meetings were held to deliberate on issues such as the appropriate structure for PPI in India, the role of agriculture, inclusion of services, and the use of existing Input-Output tables.
• Categories covered under PPI in India
  • Primary Articles, Fuel and Power, Manufactured Products
    • The index basket of the PPI covers commodities falling under three major groups: Primary Articles, Fuel and Power, and Manufactured Products.
    • The Manufactured Products group has been reclassified at the 2-digit level following the National Industrial Classification (NIC) 2008.
  • Inclusion of services
    • The Working Group recommended the inclusion of 15 services in the PPI basket initially.
    • The coverage of the service sector is to be extended to all key sectors on an urgent basis during the experimental phases of PPI implementation.

Comparison with Other Indices

• PPI vs. CPI

Aspect	Producer Price Index (PPI)	Consumer Price Index (CPI)
Definition	Measures the average change in prices received by domestic producers for their output	Measures the average change in prices paid by consumers for a basket of goods and services
Scope	Includes prices of goods and services at the wholesale level, excluding indirect taxes	Includes prices of goods and services at the retail level, including indirect taxes
Purpose	Used to deflate revenue streams and measure real growth in output	Used to adjust income and expenditure streams for changes in the cost of living
Data Source	Prices received by producers, collected from surveys and administrative records	Prices paid by consumers, collected from consumer expenditure surveys
Weighting	Weights derived from Supply Use Tables	Weights derived from Consumer Expenditure Surveys
Coverage	Excludes imports, focuses on domestic production	Includes imports, focuses on consumer purchases

• PPI vs. WPI

Aspect	Producer Price Index (PPI)	Wholesale Price Index (WPI)
Definition	Measures the average change in prices received by domestic producers for their output	Measures the average change in prices of goods at the wholesale level, including some taxes and distribution costs
Scope	Includes prices of goods and services, excluding indirect taxes	Focuses on goods, excluding services, and includes indirect taxes
Purpose	Used to measure inflation at the producer level and deflate revenue streams	Used to measure inflation at the wholesale level and track price changes in bulk transactions
Data Source	Prices received by producers, collected from surveys and administrative records	Prices at the wholesale level, collected from wholesale markets and businesses
Weighting	Weights derived from Supply Use Tables	Weights based on net traded value
Coverage	Includes services and removes multiple counting biases	Excludes services and may include multiple counting biases

Analytical Uses

• PPI as an economic indicator
  • Monitoring inflation at different stages of production
    • The Producer Price Index (PPI) is a vital tool for tracking inflation across various stages of the production process, from raw materials to finished goods. This allows for a detailed analysis of price changes at each stage, providing insights into where inflationary pressures are building up within the supply chain.
  • Predicting future consumer price inflation
    • The PPI is often used to forecast future consumer price inflation. Since producer prices typically change before consumer prices, the PPI can serve as an early indicator of inflationary trends that will eventually affect consumers. This predictive capability is crucial for policymakers and businesses to anticipate and respond to inflationary pressures.
• Role in policy-making
  • Influence on monetary policy and interest rates
    • The PPI plays a significant role in shaping monetary policy. Central banks and policymakers use PPI data to gauge inflationary pressures within the economy. If the PPI indicates rising producer prices, it may prompt central banks to increase interest rates to curb inflation. Conversely, a declining PPI might lead to lower interest rates to stimulate economic activity.
  • Use in contract adjustments and business decisions
    • PPI data is frequently used in contract adjustments to account for changes in input costs over time. Businesses incorporate PPI-based clauses in long-term contracts to ensure that prices remain fair and reflective of current market conditions. This practice helps protect both buyers and sellers from unexpected price fluctuations, ensuring stability and predictability in business transactions.

Challenges of PPI

• Data Collection and Accuracy
  • Sampling Errors and Biases: The accuracy of the Producer Price Index (PPI) can be compromised by sampling errors and biases. These arise when the sample of establishments and items is not representative of the dynamic universe of producers. Over time, the sample may deteriorate, necessitating periodic rebasing to update weights and sample items.
  • Missing Prices: The collection of PPI data can be disrupted by missing prices, especially during economic crises or disruptions like the COVID-19 pandemic. National statistical organizations (NSOs) may face increased numbers of missing prices due to temporary closures of establishments or restrictions on movement, impacting the reliability of the index.
• Methodological Issues
  • Inappropriate Use of Formulas: The use of certain index number formulas, such as the Laspeyres index, can introduce biases. These formulas may give unduly low weights to products with relatively high price increases, failing to account for substitution effects. This can result in a downward bias in the PPI.
  • Coverage and Valuation Practices: Errors and biases can also stem from inadequate coverage and inappropriate valuation practices. For instance, if the PPI is restricted to the industrial sector, it may not accurately reflect overall inflation if price changes in other sectors differ significantly.
• Sectoral and Commodity Coverage
  • Limited Coverage of Services: Traditionally, the PPI has focused more on goods than services. This limited coverage can lead to an incomplete picture of producer price inflation, especially in economies where the service sector constitutes a significant portion of economic activity.
  • Exclusion of New Items: New items produced after the base period may be excluded from the PPI, leading to biases if their prices differ significantly from those of matched items. This exclusion can result in a non-representative index that does not fully capture current market conditions.
• International Comparability
  • Differences in Methodologies: Variations in the methodologies used by different countries to compile the PPI can hinder international comparability. For example, while some countries may include import and export price indices as part of their PPI, others may not, leading to discrepancies in the measurement of producer price inflation.
  • Adapting Best Practices: Implementing international best practices, such as those used in Australia, the UK, and New Zealand, can be challenging. These models may require significant adjustments to existing data collection and processing systems, posing logistical and financial challenges.
• Economic and Policy Implications
  • Impact on National Accounts: The PPI is often used for deflating values in national accounts. If the PPI coverage is inadequate, it can lead to biases in the measurement of real economic growth. For example, using only a manufacturing PPI to deflate industrial output may not accurately reflect price changes in other sectors like quarrying and construction.
  • Policy Formulation: Inaccurate PPI data can affect policy formulation, particularly in areas like monetary policy and inflation targeting. Policymakers rely on accurate PPI data to make informed decisions about interest rates and other economic policies. Errors in the PPI can lead to suboptimal policy decisions.

Future Directions

• Methodological Improvements
  • Addressing Sampling Errors and Biases: Periodic rebasing and updating of weights and sample items to ensure the Producer Price Index (PPI) remains representative of the dynamic universe of producers. Implementing robust sampling techniques to minimize errors and biases arising from non-representative samples of establishments and items.
  • Adopting Advanced Index Number Formulas: Exploring the use of superlative index number formulas, such as the Törnqvist or Fisher indices, which better account for substitution effects and provide more accurate measures of price changes. Transitioning from the traditional Laspeyres index formula, which may introduce biases due to its inability to capture substitution effects.
• Expanding Coverage
  • Comprehensive Inclusion of Services: Gradually expanding the coverage of the PPI to include a broader range of service sectors, ensuring a more comprehensive representation of the economy. Developing robust methodologies and data collection mechanisms to accurately capture price changes in the dynamic service sector.
  • Incorporating New Products and Technologies: Establishing processes to regularly update the PPI basket to include new products and technologies as they emerge, ensuring the index remains relevant and reflective of current market conditions. Addressing challenges related to quality adjustment and incorporating technological advancements in the measurement of price changes.
• International Harmonization
  • Aligning with Best Practices: Adopting international best practices and methodologies used by countries like Australia, the UK, and New Zealand to enhance the comparability and consistency of the PPI. Participating in international initiatives and collaborations to harmonize PPI compilation methods and facilitate cross-country comparisons.
  • Improving Data Dissemination: Enhancing the dissemination of PPI data by providing more detailed breakdowns, analytical tools, and user-friendly platforms to cater to the diverse needs of stakeholders. Promoting transparency and accessibility of PPI data to support informed decision-making and policy formulation.
• Institutional Strengthening
  • Enhancing Data Collection Mechanisms: Investing in robust data collection systems, leveraging technology and administrative data sources to improve the timeliness, accuracy, and efficiency of price data collection. Strengthening collaboration with industry associations, trade bodies, and other stakeholders to facilitate data sharing and improve the quality of price data.
  • Capacity Building and Resource Allocation: Providing adequate resources and training to statistical agencies responsible for PPI compilation to ensure the adoption of best practices and continuous improvement. Fostering collaboration and knowledge-sharing among national and international statistical organizations to facilitate capacity building and skill development.

Conclusion

The Producer Price Index (PPI) in India is a crucial economic indicator that measures price changes from the producer’s perspective, providing insights into inflationary pressures before they reach consumers. As India aligns with global practices by transitioning from the Wholesale Price Index (WPI) to the PPI, it aims to offer a more comprehensive and accurate measure of inflation, initially focusing on goods with plans to gradually include services.

Practice Question

Distinguish between Wholesale Price Index (WPI) and Producer Price Index (PPI) and explain the way Headline Inflation is measured in India. (250 words)