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.

Stabilization, or keeping output at its natural level, and descending inflation are the major objectives of the monetary policy makers. Inflation targeting is an approach to monetary policy, where the Central Bank aims to achieve either a particular level of inflation or more commonly keep inflation within the range. But the major problem is on deciding which measure of inflation to target. First, volatility of prices in headline or measured inflation restricts it from being a useful basis for monetary policy decisions. Second, especially for the Indian case, there are many price indices and the index to choose for analyzing the inflationary scenario that is controversial. There is no retail price index, which could be effectively used to analyze inflation. The general practice is to use the Wholesale Price Index (WPI), which does not include theservice sector as the measure of headline inflation.1 Due to the expansion of the service sector in recent years, this practice is questionable. However, we follow the general practice and take WPI for analyzing core inflation.

Core inflation has the advantages as it excludes the volatile component, which maybe outside the purview of monetary policy, from headline inflation. It does so by identifying inflation caused by demand shocks-core inflation. But theoretical restrictions are required to identify demand shocks.