Measuring trend inflation in India

Abstract

Central to monetary policy is the concept of trend inflation to which actual inflation outcomes are expected to converge after short run fluctuations die out. Accordingly, the inflation target needs to be fixed in alignment with trend inflation to avoid unhinging inflation expectations and flattening the aggregate supply curve or imparting a deflationary bias to the economy. Results from a regime switching model applied to a hybrid New Keynesian Philips curve suggest a steady decline in trend inflation since 2014 to 4.1–4.3 per cent just before COVID-19 struck. This points to maintaining the inflation target at 4 per cent for India.