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A Dynamic Factor Model for Icelandic Core Inflation


  • Bjarni G. Einarsson


Using monthly data on 230 subcomponents of the consumer price index, a new measure of core inflation in Iceland is proposed based on a dynamic factor model. The measure is then compared along several dimensions to the set of core inflation measures currently monitored by the Central Bank of Iceland (including both exclusion and statistical measures). This comparison indicates that the dynamic factor measure outperforms other core inflation measures for the period March 1997 to July 2014 in terms of matching the mean of CPI inflation while having lower volatility. When examining subsamples determined by the availability of other measures of core inflation, the results are less clear-cut - the measures that match the mean of CPI inflation provide little or no reduction in volatility, while the dynamic factor measure does not match the mean of inflation perfectly but has the advantage of lower volatility. An evaluation of whether the core inflation measures are unbiased predictors of future inflation indicates that, of all the measures examined, only the dynamic factor measure and one exclusion measure (core index 1) are unbiased predictors, both of them weakly exogenous. A potential drawback of the dynamic factor model approach is that its core inflation estimate may be subject to large revisions when new data become available. However, the results indicate that the dynamic factor measure is quite robust to the addition of new data. Thus the results of the paper indicate that the dynamic factor measure of core inflation may be a valuable complement to the set of measures of core inflation currently monitored by the Central Bank of Iceland.

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  • Bjarni G. Einarsson, 2014. "A Dynamic Factor Model for Icelandic Core Inflation," Economics wp67, Department of Economics, Central bank of Iceland.
  • Handle: RePEc:ice:wpaper:wp67

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    References listed on IDEAS

    1. Cogley, Timothy, 2002. "A Simple Adaptive Measure of Core Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 94-113, February.
    2. Necati Tekatli, 2010. "A New Core Inflation Indicator for Turkey," Central Bank Review, Research and Monetary Policy Department, Central Bank of the Republic of Turkey, vol. 10(2), pages 9-21.
    3. Marlene Amstad & Ye Huan & Guonan Ma, 2014. "Developing an underlying inflation gauge for China," Working Papers 853, Bruegel.
    4. Mark A. Wynne, 2008. "Core inflation: a review of some conceptual issues," Review, Federal Reserve Bank of St. Louis, vol. 90(May), pages 205-228.
    5. Michael Kirker, 2010. "What drives core inflation? A dynamic factor model analysis of tradable and nontradable prices," Reserve Bank of New Zealand Discussion Paper Series DP2010/13, Reserve Bank of New Zealand.
    6. Cristadoro, Riccardo & Forni, Mario & Reichlin, Lucrezia & Veronese, Giovanni, 2005. "A Core Inflation Indicator for the Euro Area," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(3), pages 539-560, June.
    7. Mikael Khan & Louis Morel & Patrick Sabourin, 2013. "The Common Component of CPI: An Alternative Measure of Underlying Inflation for Canada," Staff Working Papers 13-35, Bank of Canada.
    8. Marlene Amstad & Simon Potter & Robert Rich, 2014. "The FRBNY Staff Underlying Inflation Gauge: UIG," BIS Working Papers 453, Bank for International Settlements.
    9. Domenico Giannone & Troy D. Matheson, 2007. "A New Core Inflation Indicator for New Zealand," International Journal of Central Banking, International Journal of Central Banking, vol. 3(4), pages 145-180, December.
    10. Marlene Amstad & Simon M. Potter, . "Real time underlying inflation gauges for monetary policymakers," Staff Reports, Federal Reserve Bank of New York.
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    Cited by:

    1. Aðalheiður Ó. Guðlaugsdóttir & Lilja S. Kro, 2018. "The common component of the CPI - A trendy measure of Icelandic underlying inflation," Economics wp78, Department of Economics, Central bank of Iceland.

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