Academic journal article IUP Journal of Applied Economics

Some Measures of Core Inflation for India

Academic journal article IUP Journal of Applied Economics

Some Measures of Core Inflation for India

Article excerpt

This paper discusses in some detail various existing approaches of measuring core inflation, evaluating their potential advantages and disadvantages. Then a variety of measures of core inflation for India based on three methods are constructed. Among these measures, three are based on conventional ex-food and energy principle and one measure excludes 15 of the most volatile components. While constructing exclusion-based indices of core inflation, measures are constructed in such a way that only a small weight gets excluded from the index of the core inflation. The other two core measures that are variations of 'Neo-Edgeworthian index' are constructed by reweighting 69 disaggregated components series of WPI. Then another class of core measures is computed based on weighted exponential smoothing which was primarily developed by Cogley (2002). Estimates of core inflation based on their indexes are then calculated for the period from 1995 to 2007 (on monthly basis). Subsequently, an empirical evaluation of these estimated core measures is performed. While choosing criteria for empirical evaluation, the following were considered: first, forward-looking monetary policy framework, viz., tracking trend inflation, and second, an attractor property of core inflation and their relative predictive power for future transient movement in inflation. The empirical findings show that the weighted exponential smoothing-based measures of core inflation perform far better compared to all other measures of core inflation in terms of similarity in means, lower volatility, tracking trend inflation and an ability to predict future transient movement in headline inflation at both 12-month and 24-month horizons.

(ProQuest: ... denotes formulae omitted.)

Introduction

There has been a growing consensus in recent years among the central bankers about price stability being the main goal of monetary policy. This consensus has developed as a result of a long list of empirical research that shows low and stable inflation is conductive to economic growth1. As a result, a number of central bankers have established either explicit or implicit inflation target2 as the central objective of monetary policy. One important operational issue for inflation targeting concerns the following: what price index to use as a target variable? There is some agreement that central banks should be concentrating on stabilizing headline inflation, but at the same time it is pointed out that headline inflation is heavily affected by non-monetary (supply shock) factors such as oil price, food and administered prices which are beyond the control of monetary authority.

Thus, the monetary policy makers are confronted with price changes, some of which are permanent and some are temporary. Then, it is essential for any monetary authority to distinguish between these two components in inflation data. In order to do this, economists have developed an alternative measure for headline inflation, called core inflation, that attempts to identify the permanent trend in inflation by eliminating temporary fluctuations. The problem is that there is no single agreed approach or method of measuring core inflation because the core inflation itself is unobservable and has to be estimated. This task is a difficult one. One objective of this study is to understand the concept and measurement aspects of core inflation. As noted above, there is a general notion about core inflation regarding its operational use in monetary policy framework, i.e., its use as either an explicit or implicit target variable. Hence, a second objective is to evaluate empirical measures of core inflation in this framework.

Since, monetary policy affects the economy with monetary transmission lags3, an inflationtargeting central bank has to make its best assessment of future inflation (that is usually the forecast of core or underlying inflation) when deciding the monetary policy. When future core inflation is expected to exceed the target (here the target either may be headline inflation or core inflation itself), monetary policy should be tightened (or to increase short-term interest rate). …

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