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Using the First Principal Component as a Core Inflation Indicator

Authors 
Afonso Gonçalves da Silva
Pedro Duarte Neves
José Ferreira Machado
Publication Year 
2001
JEL Code 
C43 - Index Numbers and Aggregation
E31 - Price Level; Inflation; Deflation
E52 - Monetary Policy (Targets, Instruments, and Effects)
Abstract 
This paper investigates the consequences of non-stationarity for the principal components analysis and suggests a data transformation that allows obtaining smoother series for the first principal component to be used as a core inflation indicator. The paper also introduces a theoretical model, which allows interpreting core inflation as a common stochastic trend to the year-on-year rates of change of the price indices of the basic CPI items. Finally, it is shown that the first principal component computed in real time meets the evaluation criteria introduced in Marques et al. (2000).
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