01.12.2014

New working paper on core inflation in Iceland

Working paper no. 67, „A Dynamic Factor Model for Icelandic Core Inflation“, by Bjarni G. Einarsson has been published. The paper presents a new measure of core inflation in Iceland using a dynamic factor model and compares it to existing measures in Iceland.

Using monthly data on 210 subcomponents of the Consumer Price Index, the paper proposes a new measure of core inflation in Iceland based on a dynamic factor model. This new 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.

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.


The paper is accessible at the bank‘s website: Working papers

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