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Combining Forecasts under Structural Breaks Using Graphical LASSO

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  • Tae-Hwy Lee
  • Ekaterina Seregina

Abstract

In this paper we develop a novel method of combining many forecasts based on a machine learning algorithm called Graphical LASSO (GL). We visualize forecast errors from different forecasters as a network of interacting entities and generalize network inference in the presence of common factor structure and structural breaks. First, we note that forecasters often use common information and hence make common mistakes, which makes the forecast errors exhibit common factor structures. We use the Factor Graphical LASSO (FGL, Lee and Seregina (2023)) to separate common forecast errors from the idiosyncratic errors and exploit sparsity of the precision matrix of the latter. Second, since the network of experts changes over time as a response to unstable environments such as recessions, it is unreasonable to assume constant forecast combination weights. Hence, we propose Regime-Dependent Factor Graphical LASSO (RD-FGL) that allows factor loadings and idiosyncratic precision matrix to be regime-dependent. We develop its scalable implementation using the Alternating Direction Method of Multipliers (ADMM) to estimate regime-dependent forecast combination weights. The empirical application to forecasting macroeconomic series using the data of the European Central Bank's Survey of Professional Forecasters (ECB SPF) demonstrates superior performance of a combined forecast using FGL and RD-FGL.

Suggested Citation

  • Tae-Hwy Lee & Ekaterina Seregina, 2022. "Combining Forecasts under Structural Breaks Using Graphical LASSO," Papers 2209.01697, arXiv.org, revised Sep 2023.
  • Handle: RePEc:arx:papers:2209.01697
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    References listed on IDEAS

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    1. Ledoit, Olivier & Wolf, Michael, 2004. "A well-conditioned estimator for large-dimensional covariance matrices," Journal of Multivariate Analysis, Elsevier, vol. 88(2), pages 365-411, February.
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    3. Tae-Hwy Lee & Ekaterina Seregina, 2020. "Optimal Portfolio Using Factor Graphical Lasso," Working Papers 202025, University of California at Riverside, Department of Economics.
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    7. Bai, Jushan, 2010. "Common breaks in means and variances for panel data," Journal of Econometrics, Elsevier, vol. 157(1), pages 78-92, July.
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    More about this item

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C38 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Classification Methdos; Cluster Analysis; Principal Components; Factor Analysis
    • C55 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Large Data Sets: Modeling and Analysis

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