Forecasting economic time series using targeted predictors

摘要

This paper studies two refinements to the method of factor forecasting. First, we consider the method of quadratic principal components that allows the link function between the predictors and the factors to be non-linear. Second, the factors used inthe forecasting equation are estimated in a way to take into account that the goal is to forecast a specific series. This is accomplished by applying the method of principal components to 'targeted predictors' selected using hard and soft thresholding rules. Our three main findings can be summarized as follows. First, we find improvements at all forecast horizons over the current diffusion index forecasts by estimating the factors using fewer but informative predictors. Allowing for non-linearity oftenleads to additional gains. Second, forecasting the volatile one month ahead inflation warrants a high degree of targeting to screen out the noisy predictors. A handful of variables, notably relating to housing starts and interest rates, are found to havesystematic predictive power for inflation at all horizons. Third, the targeted predictors selected by both soft and hard thresholding changes with the forecast horizon and the sample period. Holding the set of predictors fixed as is the current practiceof factor forecasting is unnecessarily restrictive.