Navigating with a compass: Charting the course of underlying inflation

António Rua, Nuno Lourenço and João Quelhas

Working Papers from Banco de Portugal, Economics and Research Department

Abstract: We propose a novel tool to gauge price pressures resorting to circular statistics, the so-called inflation compass. We show that it provides a reliable indication on inflationary pressures in the euro area by focusing on key episodes of high and low inflation since the monetary union inception. Unlike most alternative measures of underlying inflation, the inflation compass does not exclude any subitems of inflation, ensuring that all disaggregated information is taken on board. Moreover, it is not subject to revisions, providing policymakers with real-time signals about the course of underlying inflation, while being easily understood and visually appealing. We also provide evidence of the usefulness of the inflation compass to forecast overall inflation up to 36 months ahead, even during periods of increased turbulence, such as those marked by the COVID-19 pandemic or the recent inflation surge. Our findings indicate that the inflation compass surpasses other widely used measures of underlying inflation for the euro area, leading to statistically significant improvements in forecast accuracy. Lastly, we show that our approach can handle large-dimensional data by leveraging on finer product-level and country-level data. In such environment, the inflation compass still exhibits higher accuracy, underscoring its robustness and reliability.

JEL-codes: C53 C55 E31 E37 (search for similar items in EconPapers)
Date: 2023
New Economics Papers: this item is included in nep-eec and nep-mon
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