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Sveriges Riksbank (Central Bank of Sweden) Working Paper Series, Sveriges Riksbank (Central Bank of Sweden)

No 254:
Refining Stylized Facts from Factor Models of Inflation

Ferre De Graeve () and Karl Walentin ()

Abstract: Factor models of disaggregate inflation indices suggest that sectoral shocks generate the bulk of sectoral inflation variance, but no persistence. Aggregate shocks, by contrast, are the root of sectoral inflation persistence, but have negligible relative variance. We show that simple factor models do not cope well with essential features of price data. In particular, sectoral inflation series are subject to features such as measurement error, sales and item substitutions. In factor models, these blow up the variance of sector-specific shocks, while reducing their persistence. We control for such effects by estimating a refined factor model and find that inflation variance is driven by both aggregate and sectoral shocks. Sectoral shocks, too, generate substantial inflation persistence. Both findings contrast with earlier evidence from factor models, but align well with recent micro evidence. Our results have implications for the foundations of price stickiness, and provide quantitative inputs for calibrating models with sectoral heterogeneity.

Keywords: Inflation persistence; sticky prices; factor model; sectoral inflation; (follow links to similar papers)

JEL-Codes: E31; E32; (follow links to similar papers)

41 pages, August 1, 2011, Revised October 1, 2013

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