DP3097 A Core Inflation Index for the Euro Area

Author(s): Riccardo Cristadoro, Mario Forni, Lucrezia Reichlin, Giovanni Veronese
Publication Date: December 2001
Keyword(s): core inflation, dynamic factor model, inflation forecast, monetary policy
JEL(s):
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3097

This Paper proposes an index of core inflation for the euro area which exploits information from a large panel of time series on disaggregated prices, industrial production, labour market indicators, financial and monetary variables. The index is the result of a smoothing operation at both the cross-sectional and time series level. By extracting the common component of national inflation and disregarding the idiosyncratic one, we clean inflation from measurement error, discrepancies in data recording and dynamics originated by national or sectoral idiosyncratic shocks (cross-sectional smoothing). By extracting the component with periodicity longer than one year we clean from high frequency variation and seasonal components which are not relevant for monetary policy (time series smoothing). The indicator is shown to have a number of desirable characteristics and to perform very well as a forecaster of the euro area harmonized consumer price index at one and two years horizon, which is the relevant horizon for the ECB monetary policy.