The deflator problem

NSO should build producer price indices and apply double deflation methodology to GDP data to avoid distortions

OFFICIAL DATA SHOWS that the Indian economy has been growing at 7-8 per cent in recent times. While economic activity seems to have recovered strongly after the pandemic, the actual improvement is uncertain because there are measurement issues. One important issue lies with the GDP deflator. Several experts wrote about this problem after the release of the 2011-12 base year series of national accounts. It’s time to revisit this issue.

According to the latest figures, nominal GDP increased by 10.1 per cent in the third quarter of 2023-24 (Octoberdecember). This translated into a real growth of 8.4 per cent, implying that the deflator was 1.7 per cent. Could India’s inflation be so low? We know this is not plausible. So what is going on?

It may help to start with a disclaimer. The statistical problems are quite technical, and get very complex, very quickly. Any brief explanation will therefore need to generalise and sweep away this complexity, so that the outlines of the problem can be perceived clearly. With that caveat, let’s proceed.

In the old GDP measurement methodology, estimates of real GDP relied heavily on volume-based indices such as the index of industrial production. Real growth (for the most part) was calculated directly, and a deflator was then applied to produce a nominal growth figure. Hence, problems in the deflator did not really matter for real growth rate.

Under a new methodology adopted in 2015, GDP is measured in nominal terms, which is then deflated by price indices to derive the real numbers. the de flat or has therefore become crucial. If the deflator underestimates actual inflation, then real growth will be overstated. This is what has been happening for the last year.

There are two separate problems with India's GDP deflator.

First, the National Statistics Office (NSO) does not use the international standard measure of output prices — the producer price index — to deflate GDP. This is because India does not have a PPI. The NSO proxies the PPI with the wholesale price index (WPI). However, the WPI does not track producer prices very well. It is, in fact, heavily skewed towards commodities such as oil and steel which are essential inputs in commodity importing countries like India. Also, the WPI does not measure the price of services, and services constitute two-thirds of the economy.

This skew in the composition of WPI means that whenever commodity prices fall steeply, the WPI will decline, even if producer prices are still rising. This has been a major issue recently. Since September 2022, consumer price index (CPI) inflation has been above 5 per cent, as producers kept increasing prices, but WPI inflation has steadily declined, because global commodity prices have fallen. During April-december, 2023, WPI inflation averaged -1.0 per cent. This persistent fall in WPI inflation artificially inflated real GDP during 2023-24.

Second, most G20 countries calculate real gross value added (GVA) in the manufacturing sector using a methodology known as double deflation. In this method, nominal outputs are deflated using an outputde flat or, while inputs are deflated using a separate input deflator. Then the real inputs are subtracted from real outputs to derive real GVA. India, by contrast, deflates nominal numbers using a single deflator.

Why does this matter? It matters because if input prices diverge from output prices, single deflation can misstate growth by a big margin.

Consider what has been happening recently. When the price of inputs falls and price of output increases, profits increase and nominal value added goes up (it helps to think ofg va as profits, which go up when input prices fall ). Since real GDP is supposed to be measured at“constant prices ”, this increaseneeds to be deflated away. double deflation will do this easily. But single deflation using an input price index like WPI will amplify the nominal increase. So, if the nominal increase in GVA is 10 per cent as the result of rising profits, while WPI falls by 1 per cent, the real increase will be calculated as 11 per cent, even if real output has not changed at all.

Can anything be done to quickly resolve this problem?

There is an interim solution that can be easily applied. The NSO can start using the CPI series to deflate nominal value added. The CPI is closer to producer prices than the WPI.

It is interesting to consider what would happen if CPI is used as a deflator for manufacturing GDP computation for 2023-24. Official numbers show that for the first three quarters, nominal growth rates in this sector were 2.2, 12.0, and 10.6 per cent respectively, while real growth rates were 5.0, 14.4 and 11.6 per cent. CPI inflation (excluding food, fuel and house rent) for these three quarters were 5.9, 5.1 and 4.4 per cent. If the correct deflator had been in line with this CPI inflation, then real manufacturing growth rates would instead have been -3.7, 6.9 and 6.2 per cent for the three quarters.

The change to CPI makes even more sense in the services sector. CPI has extensive information on price movements in various services sub-sectors. It would make a big difference to the estimated 2023-24 growth figures in trade/transport/communication and financial services, bringing down their growth rates by around 6 and 4 percentage points respectively.

In summary, whenever there is a collapse of global commodity prices that pushes the Wpi-based deflator far below the CPI, the real GDP growth rate of India is likely to be overestimated. Similarly, as the gap between input and output inflation starts to close, the problem will diminish. But that could also send a misleading signal, because it might seem that growth is slowing, when only the measurement bias is disappearing.

The CPI-WPI differential gives a rough indication of the degree to which the real GDP numbers might be distorted. Given how important the GDP data is, it is imperative that the NSO develops producer price indices and applies the double deflation methodology to avoid these distortions.