A new composite leading indicator of inflation for the UK: a Kalman filter approach

The principal objective of this paper is to develop a new approach to the construction of composite leading indicators using the signal extraction capabilities of the powerful Kalman filter. The resultant leading indicator properties are found to outperform those already derived using the Central Statistical Office methodology in the UK. A secondary aim of this paper is to compare the performance of the Divisia M4 monetary index with the standard Simple Sum measure of broad money in the context of composite leading indicators of inflation in the United Kingdom. The leading indicators proposed provide useful turning point information for inflation and indicators constructed using a Divisia index measure of money are found to be more closely related to the inflation reference cycle than indicators using their Simple Sum counterparts in all cases. Evidence presented here demonstrates the power of the Kalman filter as a robust signal extraction technique capable of producing the best parameter estimates over time. Further research into the development of Kalman filters for the construction of leading indicators is recommended.