A Study on the Dynamic Behaviour of Headline Versus Core Inflation: Evidence from India

Abstract

This article attempts to understand the dynamic response of core inflation and headline inflation to macroeconomic variables in the context of India. First, core inflation is calculated using the conventional exclusion measure (excluding food and energy components) and the statistical measure (asymmetrical trimmed mean, weighted median and exponential smoothing approach) by taking the monthly Consumer Price Index y-o-y inflation data from January 2012 to June 2018. Next, the study performed the comparative analysis to understand the dynamic response of both core inflation and headline inflation to different demand and supply shocks through Structural Vector Autoregressive Technique, Impulse Response Function and the Forecast Error Variance Decomposition. The findings suggest that trimming 20 per cent of the highly volatile components from the overall inflation can serve as a better proxy for the underlying medium and long-term trend in the headline inflation. Furthermore, the comparison made between headline inflation and core inflation shows that the key drivers for core inflation is the demand-side components such as real money growth, whereas headline inflation is mostly driven by the supply-side components in the context of India. The variations in core inflation are mainly observed because of the change in monetary policy decisions, hence making core inflation an important part the policy decision making. Core inflation indicates the underlying demand pressure, which can help policymakers to set adequate key policy rates to target overall inflation.