8/2016 Nicolas Reigl. Forecasting the Estonian Rate of Inflation using Factor Models

Working Papers of Eesti Pank 8/2016

The paper presents forecasts of the headline and core inflation in Estonia with factor models in a recursive pseudo out-of-sample framework. The factors are constructed with a principal component analysis and are then incorporated into vector autoregressive forecasting models. The analyses show that certain factor-augmented vector autoregressive models improve upon a simple univariate autoregressive model but the forecasting gains are small and not systematic. Models with a small number of factors extracted from a large dataset are best suited for forecasting headline inflation. In contrast models with a larger number of factors extracted from a small dataset outperform the benchmark model in the forecast of Estonian headline and, especially, core inflation.

JEL classification: C32, C38, C53

DOI: 10.23656/25045520/82016/0002

Keywords: Factor models, factor-augmented vector autoregressive models, factor analysis, principal components, inflation forecasting, forecast evaluation, Estonia 

E-mail: nicolas.reigl [at] eestipank.ee

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The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank or the Eurosystem.