Forecasting using targeted diffusion indexes
The simplicity of the standard diffusion index model of Stock and Watson has certainly contributed to its success among practitioners, resulting in a growing body of literature on factor-augmented forecasts. However, as pointed out by Bai and Ng, the ranked factors considered in the forecasting equation depend neither on the variable to be forecast nor on the forecasting horizon. We propose a refinement of the standard approach that retains the computational simplicity while coping with this limitation. Our approach consists of generating a weighted average of all the principal components, the weights depending both on the eigenvalues of the sample correlation matrix and on the covariance between the estimated factor and the targeted variable at the relevant horizon. This 'targeted diffusion index' approach is applied to US data and the results show that it outperforms considerably the standard approach in forecasting several major macroeconomic series. Moreover, the improvement is more significant in the final part of the forecasting evaluation period. Copyright © 2009 John Wiley & Sons, Ltd.
Volume (Year): 29 (2010)
Issue (Month): 3 ()
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- Jushan Bai & Serena Ng, 2000.
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- Michael ARTIS & Anindya BANERJEE & Massimiliano MARCELLINO, 2001. "Factor Forecasts for the UK," Economics Working Papers ECO2001/15, European University Institute.
- Bai, Jushan & Ng, Serena, 2008. "Forecasting economic time series using targeted predictors," Journal of Econometrics, Elsevier, vol. 146(2), pages 304-317, October.
- James H. Stock & Mark W. Watson, 2007.
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- James H. Stock & Mark W. Watson, 2005. "Implications of Dynamic Factor Models for VAR Analysis," NBER Working Papers 11467, National Bureau of Economic Research, Inc.
- Amengual, Dante & Watson, Mark W., 2007. "Consistent Estimation of the Number of Dynamic Factors in a Large N and T Panel," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 91-96, January.
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