| Summary: | Using monthly data on 230 subcomponents of the consumer price index, a new measure of core inflation in Iceland is proposed based on a dynamic factor model. The measure is then compared along several dimensions to the set of core inflation measures currently monitored by the Central Bank of Iceland (including both exclusion and statistical measures). This comparison indicates that the dynamic factor measure outperforms other core inflation measures for the period March 1997 to July 2014 in terms of matching the mean of CPI inflation while having lower volatility. When examining subsamples determined by the availability of other measures of core inflation, the results are less clear-cut - the measures that match the mean of CPI inflation provide little or no reduction in volatility, while the dynamic factor measure does not match the mean of inflation perfectly but has the advantage of lower volatility. An evaluation of whether the core inflation measures are unbiased predictors of future inflation indicates that, of all the measures examined, only the dynamic factor measure and one exclusion measure (core index 1) are unbiased predictors, both of them weakly exogenous. A potential drawback of the dynamic factor model approach is that its core inflation estimate may be subject to large revisions when new data become available. However, the results indicate that the dynamic factor measure is quite robust to the addition of new data. Thus the results of the paper indicate that the dynamic factor measure of core inflation may be a valuable complement to the set of measures of core inflation currently monitored by the Central Bank of Iceland.
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