In recent years, researchers have investigated many di¤erent ways of forecasting an eco-nomic time series using a large number of predictors—say, 40 or more (e.g., Stock andWatson, 1999, 2002, 2003, 2005; Bernanke, Boivin and Eliasz, 2005; Giannone, Reichlinand Sala, 2004; Forni, Hallin, Lippi and Reichlin, 2005). When the number of predictorsis large relative to the available sample size, one must constrain the estimation of theforecasting model in some way in order to avoid the perils of over…tting, and the manymethods di¤er mainly in how they do so. The methods have one aspect in common,however: they are atheoretical in the sense that restrictions from economic theory areeschewed.
A consistent result in this work is that these large-dataset methods outperformvarious naive and semi-sophisticated benchmarks including random walk forecasts, simpleunivariate time series models, and, in some cases, simple models motivated by economictheory.While these pioneering results are tantalizing, their importance for practical fore-casting is di¢cult to assess for two related reasons. First, arguably none of the bench-marks used in this research is used for practical forecasting. While the simple bench-marks are probably the right starting point for assessing new methods, ultimately we carewhether the new methods outperform standard practice or best practice in forecasting.Second, comparison to real-world forecasting methods is complicated by the issue of datarevisions. Many macro time series are heavily revised through time. Real-world forecastsuse the noisy early vintages available in real-time; large-dataset forecasting research hasbeen conducted almost exclusively with a single vintage of revised data.Bernanke and Boivin (2003) provide a notable exception. They use a real-timedataset to assess various large dataset forecasting methods and they include a comparisonto the Fed’s Greenbook forecast. Two results are especially interesting and provocative.
More speci…cally, economics only guides the selection of variables to include in the exercise.