Underlying Composite Inflation (UCI): A Novel Indicator to Track Inflation Developments

Abstract

This paper introduces the Underlying Composite Inflation (UCI), a novel model-based indicator designed to enhance the measurement of underlying inflation in the euro area. UCI is estimated by a dynamic factor model in the frequency domain to capture the persistent component of inflation. We also provide a probabilistic evaluation of the underlying inflation dynamics, additional insights into cross-country inflation dynamics and address the challenges posed by short-term volatility and idiosyncratic factors. UCI not only offers a more stable and refined signal of underlying inflation but also exhibits superior out-of-sample forecasting performance compared to both exclusion-based and model-based alternatives. These findings underscore the potential of UCI as a valuable tool for monetary policy, inflation monitoring, and risk assessment.

Keywords: underlying inflation, inflation trend, dynamic factor model, frequency domain analysis

JEL Classification: C22, C53, C55, E31, E37