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Forecasting Using Targeted Diffusion Indexes

  • Francisco Craveiro Dias
  • Maximiano Pinheiro
  • António Rua

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 forecasted 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.

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File URL: http://www.bportugal.pt/en-US/BdP%20Publications%20Research/WP200807.pdf
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Paper provided by Banco de Portugal, Economics and Research Department in its series Working Papers with number w200807.

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Date of creation: 2008
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Handle: RePEc:ptu:wpaper:w200807
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  1. Stock, James H. & Watson, Mark W., 1999. "Forecasting inflation," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 293-335, October.
  2. De Mol, Christine & Giannone, Domenico & Reichlin, Lucrezia, 2006. "Forecasting using a large number of predictors: Is Bayesian regression a valid alternative to principal components?," Working Paper Series 0700, European Central Bank.
  3. Jushan Bai & Serena Ng, 2002. "Determining the Number of Factors in Approximate Factor Models," Econometrica, Econometric Society, vol. 70(1), pages 191-221, January.
  4. Lutz Kilian & Atsushi Inoue, 2004. "Bagging Time Series Models," Econometric Society 2004 North American Summer Meetings 110, Econometric Society.
  5. James H. Stock & Mark W. Watson, 2006. "Why Has U.S. Inflation Become Harder to Forecast?," NBER Working Papers 12324, National Bureau of Economic Research, Inc.
  6. 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, vol. 97, pages 1167-1179, December.
  7. Marcellino, Massimiliano & Stock, James H. & Watson, Mark W., 2003. "Macroeconomic forecasting in the Euro area: Country specific versus area-wide information," European Economic Review, Elsevier, vol. 47(1), pages 1-18, February.
  8. 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.
  9. Michael ARTIS & Anindya BANERJEE & Massimiliano MARCELLINO, 2001. "Factor Forecasts for the UK," Economics Working Papers ECO2001/15, European University Institute.
  10. Boivin, Jean & Ng, Serena, 2006. "Are more data always better for factor analysis?," Journal of Econometrics, Elsevier, vol. 132(1), pages 169-194, May.
  11. Jushan Bai & Serena Ng, 2009. "Boosting diffusion indices," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 24(4), pages 607-629.
  12. Inoue, Atsushi & Kilian, Lutz, 2005. "How Useful is Bagging in Forecasting Economic Time Series? A Case Study of US CPI Inflation," CEPR Discussion Papers 5304, C.E.P.R. Discussion Papers.
  13. 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.
  14. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-62, April.
  15. James H. Stock & Mark W. Watson, 1998. "Diffusion Indexes," NBER Working Papers 6702, National Bureau of Economic Research, Inc.
  16. Bai, Jushan & Ng, Serena, 2008. "Forecasting economic time series using targeted predictors," Journal of Econometrics, Elsevier, vol. 146(2), pages 304-317, October.
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