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

Abstract

We analyze the interaction among the common and country specific components for the inflation rates in twelve 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 over time and the importance of common shocks has increased relatively to the 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.JEL classification: E31, C22, C51, C53.

Price Dividend Ratio and Long-Run Stock Returns: A Score-Driven State Space Model

“…A Monte Carlo analysis provides support for the proposed method. Recent empirical analyses that use our method also testify its usefulness (Delle Monache et al, 2016;Gorgi et al, 2019).…”

Forecasting with High‐Dimensional Panel VARs

“…Furthermore, Delle Monache et al . () document substantial time variation in parameters, providing additional support for our model, which allows for such variation.…”

“…Although commonalities predominate, country-specific shocks play a large role. Furthermore, Delle Monache et al (2016) document substantial time variation in parameters, providing additional support for our model, which allows for such variation.…”

“…Both these extensions are empirically relevant. There is ample evidence that volatility in empirical macroeconomic models is extremely important for forecasting (see, among many others, Clark and Ravazzolo, and Diebold, Schorfheide and Shin, ), in which case it is imperative to relax the assumption of homoscedasticity used by Canova and Ciccarelli (). However, given that time‐varying covariance matrices are non‐parsimonious, some form of shrinkage is also needed for these parameters.…”

“…Although there has been a tendency for inflation rates in the various eurozone countries to converge to one another, there are still substantive cross‐country differences, in particular around the time of the eurozone crisis. For instance, Delle Monache, Petrella and Venditti () document the relative roles of country‐specific and common shocks to euro area country inflation rates. Although commonalities predominate, country‐specific shocks play a large role.…”