Giovannelli, Alessandro and Proietti, Tommaso (2014): On the Selection of Common Factors for Macroeconomic Forecasting.

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Abstract
We address the problem of selecting the common factors that are relevant for forecasting macroeconomic variables. In economic forecasting using diffusion indexes the factors are ordered, according to their importance, in terms of relative variability, and are the same for each variable to predict, i.e. the process of selecting the factors is not supervised by the predictand. We propose a simple and operational supervised method, based on selecting the factors on the basis of their significance in the regression of the predictand on the predictors. Given a potentially large number of predictors, we consider linear transformations obtained by principal components analysis. The orthogonality of the components implies that the standard tstatistics for the inclusion of a particular component are independent, and thus applying a selection procedure that takes into account the multiplicity of the hypotheses tests is both correct and computationally feasible. We focus on three main multiple testing procedures: Holm’s sequential method, controlling the family wise error rate, the BenjaminiHochberg method, controlling the false discovery rate, and a procedure for incorporating prior information on the ordering of the components, based on weighting the pvalues according to the eigenvalues associated to the components. We compare the empirical performances of these methods with the classical diffusion index (DI) approach proposed by Stock and Watson, conducting a pseudoreal time forecasting exercise, assessing the predictions of 8 macroeconomic variables using factors extracted from an U.S. dataset consisting of 121 quarterly time series. The overall conclusion is that nature is tricky, but essentially benign: the information that is relevant for prediction is effectively condensed by the first few factors. However, variable selection, leading to exclude some of the low order principal components, can lead to a sizable improvement in forecasting in specific cases. Only in one instance, real personal income, we were able to detect a significant contribution from high order components.
Item Type:  MPRA Paper 

Original Title:  On the Selection of Common Factors for Macroeconomic Forecasting 
Language:  English 
Keywords:  Variable selection; Multiple testing; pvalue weighting. 
Subjects:  C  Mathematical and Quantitative Methods > C2  Single Equation Models ; Single Variables > C22  TimeSeries Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes C  Mathematical and Quantitative Methods > C3  Multiple or Simultaneous Equation Models ; Multiple Variables > C32  TimeSeries Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models C  Mathematical and Quantitative Methods > C3  Multiple or Simultaneous Equation Models ; Multiple Variables > C38  Classification Methods ; Cluster Analysis ; Principal Components ; Factor Models C  Mathematical and Quantitative Methods > C5  Econometric Modeling > C53  Forecasting and Prediction Methods ; Simulation Methods E  Macroeconomics and Monetary Economics > E3  Prices, Business Fluctuations, and Cycles E  Macroeconomics and Monetary Economics > E3  Prices, Business Fluctuations, and Cycles > E32  Business Fluctuations ; Cycles 
Item ID:  60673 
Depositing User:  Tommaso Proietti 
Date Deposited:  16 Dec 2014 14:22 
Last Modified:  09 Feb 2017 01:25 
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URI:  https://mpra.ub.unimuenchen.de/id/eprint/60673 