Nowcasting and Forecasting Economic Growth in the Euro Area using Principal Components

Many empirical studies have shown that factor models produce relatively accurate forecasts compared to alternative short-term forecasting models. These empirical findings have been established for different macroeconomic data sets and different forecast horizons. However, various specifications of the factor model exist and it is a topic of debate which specification is most effective in its forecasting performance. Furthermore, the forecast performances of the different specifications during the recent financial crisis are also not well documented. In this study we investigate these two issues in depth. We empirically verify the forecast performance of three factor model approaches and report our findings in an extended empirical out-of-sample forecasting competition for quarterly growth of gross domestic product in the euro area and its five largest countries over the period 1992-2012. We also introduce two extensions of existing factor models to make them more suitable for real-time forecasting. We show that the factor models have been able to systematically beat the benchmark autoregressive model, both before as well as during the financial crisis. The recently proposed collapsed dynamic factor model shows the highest forecast accuracy for the euro area and the majority of countries that we have analyzed. The forecast precision improvements against the benchmark model can range up to 77% in mean square error reduction, depending on the country and forecast horizon.