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Building composite leading indexes in a dynamic factor model framework: a new proposal

One of the most problematic aspects in the work of policy makers and practitioners is having efficient forecasting tools combining two seemingly incompatible features: ease of use and completeness of the information set underlying the forecasts. Econometric literature provides different answers to these needs: Dynamic Factor Models (DFMs) optimally exploit the information coming from large datasets; composite leading indexes represent an immediate and flexible tool to anticipate the future evolution of a phenomenon. Curiously, the recent DFM literature has either ignored the construction of leading indexes or has made unsatisfactory choices as regards the criteria for aggregating the index components and the identification of factors that feed the index. This paper fills the gap and proposes a multi-step procedure for building composite leading indexes within a DFM framework. Once selected the target economic variable and estimated a DFM based on a large target-oriented dataset, we identify the common factor shocks through sign restrictions on the impact multipliers and simulate the structural form of the model. The Forecast Error Variance Decompositions obtained over a k steps-ahead simulation horizon define k sets of weights for aggregating factors (in a different way depending on the leading horizon) in order to get composite leading indexes. This procedure is used for a very preliminar empirical exercise aimed at forecasting crude nominal oil prices. The results seem to be encouraging and support the validity of the proposal: we generate a wide range of horizon-specific leading indexes with appreciable forecasting performances.

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Paper provided by Cattaneo University (LIUC) in its series LIUC Papers in Economics with number 212.

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Length: 28 pages
Date of creation: Mar 2008
Date of revision:
Handle: RePEc:liu:liucec:212
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  1. Ben S. Bernanke & Jean Boivin, 2001. "Monetary Policy in a Data-Rich Environment," NBER Working Papers 8379, National Bureau of Economic Research, Inc.
  2. Olivier J. Blanchard & Jordi Gali, 2007. "The Macroeconomic Effects of Oil Shocks: Why are the 2000s So Different from the 1970s?," NBER Working Papers 13368, National Bureau of Economic Research, Inc.
  3. Lucrezia Reichlin & Domenico Giannone & Luca Sala, . "Monetary policy in real time," ULB Institutional Repository 2013/10177, ULB -- Universite Libre de Bruxelles.
    • Domenico Giannone & Lucrezia Reichlin & Luca Sala, 2005. "Monetary Policy in Real Time," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 161-224 National Bureau of Economic Research, Inc.
  4. Juan Francisco Rubio-Ramírez & Daniel F. Waggoner & Tao Zha, 2005. "Markov-switching structural vector autoregressions: theory and application," FRB Atlanta Working Paper 2005-27, Federal Reserve Bank of Atlanta.
  5. Giannone, Domenico & Reichlin, Lucrezia & Sala, Luca, 2002. "Tracking Greenspan: Systematic and Unsystematic Monetary Policy Revisited," CEPR Discussion Papers 3550, C.E.P.R. Discussion Papers.
  6. Jon Faust & Eric M. Leeper, 1994. "When do long-run identifying restrictions give reliable results?," FRB Atlanta Working Paper 94-2, Federal Reserve Bank of Atlanta.
  7. Forni, Mario & Hallin, Marc & Lippi, Marco & Reichlin, Lucrezia, 2003. "Do financial variables help forecasting inflation and real activity in the euro area?," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1243-1255, September.
  8. James H. Stock & Mark W. Watson, 2001. "Forecasting Output and Inflation: The Role of Asset Prices," NBER Working Papers 8180, National Bureau of Economic Research, Inc.
  9. Anindya Banerjee & Massimiliano Marcellino & Igor Masten, 2003. "Leading Indicators for Euro-area Inflation and GDP Growth," Working Papers 235, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  10. Pindyck, Robert S & Rotemberg, Julio J, 1990. "The Excess Co-movement of Commodity Prices," Economic Journal, Royal Economic Society, vol. 100(403), pages 1173-89, December.
  11. repec:tpr:qjecon:v:120:y:2005:i:1:p:387-422 is not listed on IDEAS
  12. Filippo Altissimo & Antonio Bassanetti & Riccardo Cristadoro & Mario Forni & Marco Lippi & Lucrezia Reichlin & Giovanni Veronese, 2001. "A real time coincident indicator of the euro area business cycle," Temi di discussione (Economic working papers) 436, Bank of Italy, Economic Research and International Relations Area.
  13. Carmen M. Reinhart & Peter Wickham, 1994. "Commodity Prices: Cyclical Weakness or Secular Decline?," IMF Staff Papers, Palgrave Macmillan, vol. 41(2), pages 175-213, June.
  14. Lucrezia Reichlin & Mario Forni & Marc Hallin & Marco Lippi, 2001. "Coincident and leading indicators for the Euro area," ULB Institutional Repository 2013/10137, ULB -- Universite Libre de Bruxelles.
  15. Jean-Thomas Bernard & Lynda Khalaf & Maral Kichian, 2004. "Structural Change and Forecasting Long-Run Energy Prices," Staff Working Papers 04-5, Bank of Canada.
  16. Thomas J. Sargent & Christopher A. Sims, 1977. "Business cycle modeling without pretending to have too much a priori economic theory," Working Papers 55, Federal Reserve Bank of Minneapolis.
  17. Ben S. Bernanke & Jean Boivin & Piotr Eliasz, 2004. "Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach," NBER Working Papers 10220, National Bureau of Economic Research, Inc.
  18. Kilian, Lutz, 2006. "Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market," CEPR Discussion Papers 5994, C.E.P.R. Discussion Papers.
  19. Robert S. Pindyck, 1979. "The Structure of World Energy Demand," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262661772, June.
  20. repec:tpr:qjecon:v:101:y:1986:i:1:p:85-102 is not listed on IDEAS
  21. Mario Forno & Marco Lippi & Lucrezia Reichlin & Filippo Altissimo & Antonio Bassanetti, 2003. "Eurocoin: A Real Time Coincident Indicator Of The Euro Area Business Cycle," Computing in Economics and Finance 2003 242, Society for Computational Economics.
  22. Paul Cashin & Hong Liang & C. John McDermott, 2000. "How Persistent Are Shocks to World Commodity Prices?," IMF Staff Papers, Palgrave Macmillan, vol. 47(2), pages 2.
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