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Forecasting euro area inflation using dynamic factor measures of underlying inflation

  • Camba-Méndez, Gonzalo
  • Kapetanios, George
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    Standard measures of prices are often contaminated by transitory shocks. This has prompted economists to suggest the use of measures of underlying in?ation to formulate monetary policy and assist in forecasting observed in?ation. Recent work has concentrated on modelling large datasets using factor models. In this paper we estimate factors from datasets of disaggregated price indices for European countries. We then assess the forecasting ability of these factor estimates against other measures of underlying in?ation built from more traditional methods. The power to forecast headline in?ation over horizons of 12 to 18 months is adopted as a valid criterion to assess forecasting. Empirical results for the ?ve largest euro area countries as well as for the euro area are presented. JEL Classification: E31, C13, C32

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    Paper provided by European Central Bank in its series Working Paper Series with number 0402.

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    Date of creation: Nov 2004
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    Handle: RePEc:ecb:ecbwps:20040402
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    1. Francis X. Diebold & Robert S. Mariano, 1994. "Comparing Predictive Accuracy," NBER Technical Working Papers 0169, National Bureau of Economic Research, Inc.
    2. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
    3. George Kapetanios, 2002. "Modelling Core Inflation for the UK Using a New Dynamic Factor Estimation Method and a Large Disaggregated Price Index Dataset," Working Papers 471, Queen Mary University of London, School of Economics and Finance.
    4. Quah, Danny & Vahey, Shaun P, 1995. "Measuring Core Inflation?," Economic Journal, Royal Economic Society, vol. 105(432), pages 1130-44, September.
    5. Kapetanios, George & Marcellino, Massimiliano, 2006. "A Parametric Estimation Method for Dynamic Factor Models of Large Dimensions," CEPR Discussion Papers 5620, C.E.P.R. Discussion Papers.
    6. Blanchard, Olivier Jean & Quah, Danny, 1989. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," American Economic Review, American Economic Association, vol. 79(4), pages 655-73, September.
    7. Harvey, A C & Jaeger, A, 1993. "Detrending, Stylized Facts and the Business Cycle," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(3), pages 231-47, July-Sept.
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