Divisia money in a composite leading indicator of inflation

The principal objective 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. Inflation targeting is an important component of current UK monetary policy and the construction of composite leading indicators of inflation is a potential advance over the current practice of monitoring a range of indicators of inflation. The leading indicators proposed provide useful turning point information for inflation and advocate principal component analysis as a more sophisticated weighting mechanism for the constituent components. Indicators constructed using a Divisia index measure of money were found to be more closely related to the inflation reference cycle than indicators using their Simple Sum counterparts when a principal components weighting mechanism was used.