Advanced Search
MyIDEAS: Login to save this paper or follow this series

Seeing inside the black box: Using diffusion index methodology to construct factor proxies in large scale macroeconomic time series environments

Contents:

Author Info

  • Nii Ayi Armah
  • Norman R. Swanson

Abstract

In economics, common factors are often assumed to underlie the co-movements of a set of macroeconomic variables. For this reason, many authors have used estimated factors in the construction of prediction models. In this paper, we begin by surveying the extant literature on diffusion indexes. We then outline a number of approaches to the selection of factor proxies (observed variables that proxy unobserved estimated factors) using the statistics developed in Bai and Ng (2006a,b). Our approach to factor proxy selection is examined via a small Monte Carlo experiment, where evidence supporting our proposed methodology is presented, and via a large set of prediction experiments using the panel dataset of Stock and Watson (2005). One of our main empirical findings is that our “smoothed” approaches to factor proxy selection appear to yield predictions that are often superior not only to a benchmark factor model, but also to simple linear time series models which are generally difficult to beat in forecasting competitions. In some sense, by using our approach to predictive factor proxy selection, one is able to open up the “black box” often associated with factor analysis, and to identify actual variables that can serve as primitive building blocks for (prediction) models of a host of macroeconomic variables, and that can also serve as policy instruments, for example. Our findings suggest that important observable variables include various S&P500 variables, including stock price indices and dividend series; a 1-year Treasury bond rate; various housing activity variables; industrial production; and exchange rates.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.philadelphiafed.org/research-and-data/publications/working-papers/2008/wp08-25.pdf
Download Restriction: no

Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 08-25.

as in new window
Length:
Date of creation: 2008
Date of revision:
Handle: RePEc:fip:fedpwp:08-25

Contact details of provider:
Postal: 10 Independence Mall, Philadelphia, PA 19106-1574
Web page: http://www.philadelphiafed.org/
More information through EDIRC

Order Information:
Email:
Web: http://www.phil.frb.org/econ/wps/index.html

Related research

Keywords: Macroeconomics;

Other versions of this item:

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters, in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc.
  2. Jushan Bai & Serena Ng, 2002. "Determining the Number of Factors in Approximate Factor Models," Econometrica, Econometric Society, Econometric Society, vol. 70(1), pages 191-221, January.
  3. Diebold, Francis X & Mariano, Roberto S, 1995. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 13(3), pages 253-63, July.
  4. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 115(1), pages 147-180, February.
  5. Mario Forni & Marc Hallin & Marco Lippi & Lucrezia Reichlin, 2000. "The Generalized Dynamic-Factor Model: Identification And Estimation," The Review of Economics and Statistics, MIT Press, vol. 82(4), pages 540-554, November.
  6. Stock, James H & Watson, Mark W, 1996. "Evidence on Structural Instability in Macroeconomic Time Series Relations," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 14(1), pages 11-30, January.
  7. Bai, Jushan & Ng, Serena, 2006. "Evaluating latent and observed factors in macroeconomics and finance," Journal of Econometrics, Elsevier, Elsevier, vol. 131(1-2), pages 507-537.
  8. Forni, Mario & Reichlin, Lucrezia, 1996. "Dynamic Common Factors in Large Cross-Sections," Empirical Economics, Springer, Springer, vol. 21(1), pages 27-42.
  9. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers, C.V. Starr Center for Applied Economics, New York University 99-13, C.V. Starr Center for Applied Economics, New York University.
  10. Breeden, Douglas T & Gibbons, Michael R & Litzenberger, Robert H, 1989. " Empirical Tests of the Consumption-Oriented CAPM," Journal of Finance, American Finance Association, American Finance Association, vol. 44(2), pages 231-62, June.
  11. Bai, Jushan & Ng, Serena, 2007. "Determining the Number of Primitive Shocks in Factor Models," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 25, pages 52-60, January.
  12. Thomas J. Sargent & Christopher A. Sims, 1977. "Business cycle modeling without pretending to have too much a priori economic theory," Working Papers, Federal Reserve Bank of Minneapolis 55, Federal Reserve Bank of Minneapolis.
  13. Mario Forni & Marc Hallin & Marco Lippi & Lucrezia Reichlin, 2003. "The Generalized Dynamic Factor Model. One-Sided Estimation and Forecasting," LEM Papers Series, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy 2003/13, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy.
  14. Corradi, V. & Swanson, N.R., 2000. "A Consistent Test for Nonlinear Out of Sample Predictive Accuracy," Discussion Papers, Exeter University, Department of Economics 0012, Exeter University, Department of Economics.
  15. Forni, Mario & Reichlin, Lucrezia, 1995. "Let's Get Real: A Dynamic Factor Analytical Approach to Disaggregated Business Cycle," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1244, C.E.P.R. Discussion Papers.
  16. Valentina Corradi & Norman Swanson, 2004. "Predictive Density Evaluation," Departmental Working Papers, Rutgers University, Department of Economics 200419, Rutgers University, Department of Economics.
  17. Stock, James H. & Watson, Mark W., 1999. "Forecasting inflation," Journal of Monetary Economics, Elsevier, Elsevier, vol. 44(2), pages 293-335, October.
  18. Connor, Gregory & Korajczyk, Robert A., 1988. "Risk and return in an equilibrium APT : Application of a new test methodology," Journal of Financial Economics, Elsevier, Elsevier, vol. 21(2), pages 255-289, September.
  19. Connor, Gregory & Korajczyk, Robert A, 1993. " A Test for the Number of Factors in an Approximate Factor Model," Journal of Finance, American Finance Association, American Finance Association, vol. 48(4), pages 1263-91, September.
  20. Stock J.H. & Watson M.W., 2002. "Forecasting Using Principal Components From a Large Number of Predictors," Journal of the American Statistical Association, American Statistical Association, American Statistical Association, vol. 97, pages 1167-1179, December.
  21. Corradi, Valentina & Swanson, Norman R., 2006. "Bootstrap conditional distribution tests in the presence of dynamic misspecification," Journal of Econometrics, Elsevier, Elsevier, vol. 133(2), pages 779-806, August.
  22. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
  23. Douglas T. Breeden & Michael R Gibbons & Robert H. Litzenberger, . "Empirical Tests of the Consumption-Oriented CAPM," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 7-89, Wharton School Rodney L. White Center for Financial Research.
  24. Jushan Bai & Serena Ng, 2006. "Confidence Intervals for Diffusion Index Forecasts and Inference for Factor-Augmented Regressions," Econometrica, Econometric Society, Econometric Society, vol. 74(4), pages 1133-1150, 07.
  25. Douglas T. Breeden & Michael R Gibbons & Robert H. Litzenberger, . "Empirical Tests of the Consumption-Oriented CAPM," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 07-89, Wharton School Rodney L. White Center for Financial Research.
  26. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, Elsevier, vol. 15(3), pages 373-394, March.
  27. Ben S. Bernanke & Jean Boivin, 2001. "Monetary Policy in a Data-Rich Environment," NBER Working Papers 8379, National Bureau of Economic Research, Inc.
  28. Jushan Bai, 2003. "Inferential Theory for Factor Models of Large Dimensions," Econometrica, Econometric Society, Econometric Society, vol. 71(1), pages 135-171, January.
  29. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 20(2), pages 147-62, April.
  30. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, Econometric Society, vol. 48(4), pages 817-38, May.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Kihwan Kim & Norman Swanson, 2013. "Diffusion Index Model Specification and Estimation Using Mixed Frequency Datasets," Departmental Working Papers, Rutgers University, Department of Economics 201315, Rutgers University, Department of Economics.
  2. Dahl, Christian M. & Hansen, Henrik & Smidt, John, 2009. "The cyclical component factor model," International Journal of Forecasting, Elsevier, Elsevier, vol. 25(1), pages 119-127.
  3. Valentina Corradi & Norman Swanson, 2013. "Testing for Structural Stability of Factor Augmented Forecasting Models," Departmental Working Papers, Rutgers University, Department of Economics 201314, Rutgers University, Department of Economics.
  4. Kim, Hyun Hak & Swanson, Norman R., 2014. "Forecasting financial and macroeconomic variables using data reduction methods: New empirical evidence," Journal of Econometrics, Elsevier, Elsevier, vol. 178(P2), pages 352-367.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:fip:fedpwp:08-25. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Beth Paul).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.