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Evaluating Factor Models: An Application to Forecasting Inflation in Canada

  • Marc-André Gosselin
  • Greg Tkacz

This paper evaluates the forecasting performance of factor models for Canadian inflation. This type of model was introduced and examined by Stock and Watson (1999a), who have shown that it is quite promising for forecasting U.S. inflation. Using a dimension-reduction method similar to traditional principal-components analysis, we extract a small number of factors from a sample consisting of both Canadian and U.S. data and construct four different factor models. Using parametric and non-parametric tests, we compare the forecasting performance of the factor models to various benchmark forecasting models. We conclude that factor models are as good as more elaborate models in forecasting Canadian inflation. Moreover, we find evidence that a model estimated using only U.S. data is helpful in predicting changes in the Canadian inflation rate.

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Paper provided by Bank of Canada in its series Staff Working Papers with number 01-18.

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Length: 35 pages
Date of creation: 2001
Date of revision:
Handle: RePEc:bca:bocawp:01-18
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  1. Ng, S. & Perron, P., 1994. "Unit Root Tests ARMA Models with Data Dependent Methods for the Selection of the Truncation Lag," Cahiers de recherche 9423, Universite de Montreal, Departement de sciences economiques.
  2. James H. Stock & Mark W. Watson, 1998. "Diffusion Indexes," NBER Working Papers 6702, National Bureau of Economic Research, Inc.
  3. Jonas D. M. Fisher, 2000. "Forecasting inflation with a lot of data," Chicago Fed Letter, Federal Reserve Bank of Chicago, issue Mar.
  4. Ashley, R & Granger, C W J & Schmalensee, R, 1980. "Advertising and Aggregate Consumption: An Analysis of Causality," Econometrica, Econometric Society, vol. 48(5), pages 1149-67, July.
  5. Tkacz, Greg, 2001. "Neural network forecasting of Canadian GDP growth," International Journal of Forecasting, Elsevier, vol. 17(1), pages 57-69.
  6. Jean-François Fillion & André Léonard, 1997. "La courbe de Phillips au Canada : un examen de quelques hypothèses," Staff Working Papers 97-3, Bank of Canada.
  7. Diebold, Francis X & Mariano, Roberto S, 1995. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(3), pages 253-63, July.
  8. Marc Brisson & Bryan Campbell & John Galbraith, 2001. "Forecasting Some Low-Predictability Time Series Using Diffusion Indices," CIRANO Working Papers 2001s-46, CIRANO.
  9. Bernanke, Ben S. & Boivin, Jean, 2003. "Monetary policy in a data-rich environment," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 525-546, April.
  10. Engert, Walter & Hendry, Scott, 1998. "Forecasting Inflation with the M1-VECM: Part Two," Staff Working Papers 98-6, Bank of Canada.
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