Analyzing Core Inflation in India: A Structural VAR Approach

Effective inflation targeting requires careful selection of inflation target. It is necessary to leave out noisy elements, which the monetary policy cannot control. However, this exclusion should not be done in an ad hoc basis. Rather, core inflation should be determined from the structure of the economy. This paper estimates core inflation for India, using Structural Vector Autoregression (SVAR) method. This method is based on both theory and the structure of the economy. Monthly data for Wholesale Price Index (WPI) and Index of Industrial Production (IIP) has been used, covering a long time span from January 1971 to July 2004. We analyze the impulse responses of inflation and output, test for several time series properties of core inflation and carry out a number of Granger causality tests between headline inflation, core inflation, output and a monetary aggregate.