CARLO A. FAVERO, MASSIMILIANO MARCELLINO AND FRANCESCA NEGLIA

SUMMARY
The empirical analysis of monetary policy requires the construction of instruments for future expected
inflation. Dynamic factor models have been applied rather successfully to inflation forecasting. In fact, two
competing methods have recently been developed to estimate large-scale dynamic factor models based,
respectively, on static and dynamic principal components. This paper combines the econometric literature on
dynamic principal components and the empirical analysis of monetary policy. We assess the two competing
methods for extracting factors on the basis of their success in instrumenting future expected inflation in the
empirical analysis of monetary policy. We use two large data sets of macroeconomic variables for the USA
and for the Euro area. Our results show that estimated factors do provide a useful parsimonious summary of
the information used in designing monetary policy. Copyright  2005 John Wiley & Sons, Ltd.