A two-step dynamic factor modelling approach for forecasting inflation in small open economies

Abstract

We build a dynamic factor model to forecast inflation in a small open economy. The model is estimated with both market and survey data, and a unique two-step methodology to incorporate exogenous factors. Estimations with market data provide a better fit for in-sample and out-of-sample values of inflation. More importantly, our model outperforms univariate and estimated DSGE models, the more common approaches to inflation forecasting that perform well for advanced economies. Our findings, therefore, suggest that a dynamic factor modelling approach for a small open economy such as Jamaica can be a good alternative to the preferred methods for forecasting inflation in advanced economies.