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Common Faith or Parting Ways? A Time Varying Parameters Factor Analysis of Euro-Area Inflation

Dynamic Factor Models

ISBN: 978-1-78560-353-2, eISBN: 978-1-78560-352-5

Publication date: 6 January 2016


We analyze the interaction among the common and country-specific components for the inflation rates in 12 euro area countries through a factor model with time-varying parameters. The variation of the model parameters is driven by the score of the predictive likelihood, so that, conditionally on past data, the model is Gaussian and the likelihood function can be evaluated using the Kalman filter. The empirical analysis uncovers significant variation over time in the model parameters. We find that, over an extended time period, inflation persistence has fallen and the importance of common shocks has increased relatively to that of idiosyncratic disturbances. According to the model, the fall in inflation observed since the sovereign debt crisis is broadly a common phenomenon since no significant cross-country inflation differentials have emerged. Stressed countries, however, have been hit by unusually large shocks.




The views expressed in this paper are those of the authors and do not necessarily reflect those of the Bank of England or of the Banca d’Italia. While assuming the scientific responsibility for any error in the paper, the authors would like to thank Eric Hillebrand, Siem Jan Koopman, seminar participants at the University of Glasgow, at the Banca d’Italia, at the 2014 Advances in Econometrics – Conference on Dynamic Factor Models and two anonymous referees for useful comments and suggestions.


Monache, D.D., Petrella, I. and Venditti, F. (2016), "Common Faith or Parting Ways? A Time Varying Parameters Factor Analysis of Euro-Area Inflation", Dynamic Factor Models (Advances in Econometrics, Vol. 35), Emerald Group Publishing Limited, Leeds, pp. 539-565.



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