Working Paper No. 78: The common component of the CPI: A trendy measure of Icelandic underlying inflation

Working Paper

This paper presents a new measure of underlying inflation in Iceland: the common component of the CPI. It is obtained from a factor model that is estimated using monthly data on individual subcomponents of the CPI. The results indicate that the common component is most responsive to imported inflation. Over the entire estimation period, the common component explained, on average, half of the total variation of individual subindices. Following the easing and stabilisation of inflation and inflation expectations in recent years, the majority of the variance of individual subindices is explained by sector-specific shocks over a shorter estimation period. The performance of this measure was also checked along several dimensions. It appears robust to the estimation period used, and both the level of aggregation and the impact of revisions due to real-time extraction of the common component were negligible. The common component could serve as a useful complement to existing measures of underlying inflation already monitored by the Central Bank of Iceland.

See the WP No. 78 here.

The authors are Adalheidur Ó. Gudlaugsdóttir and Lilja S. Kro, both at the Economics and Monetary Policy Department of the Central Bank of Iceland.