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cfljune2013_311

cfljune2013_311

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Estimating the trend rate of economic growth using the CFNAI
by Scott A. Brave, senior business economist, and R. Andrew Butters, graduate student, Kellogg School o Management,Northwestern Universit
This article shows how a new methodology for constructing the Chicago Fed NationalActivity Index (CFNAI) can be used to identify both the cyclical (medium-run) and trend(long-run) components of real gross domestic product (GDP) growth.
Chicago Fed Letter
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK JUNE 2013OF CHICAGO NUMBER 311
1. Differences between DF-CFNAI and CFNAI
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The figure displays the difference in every month from January 1967 through March 2013between each of the three DF-CFNAI variants (see the text for details on OLS, HR, andAR) and the CFNAI. All four indexes were standardized (i.e., transformed to have a zeromean and a standard deviation of one) and transformed into three-month moving averagesprior to calculating the differences. Shading indicates U.S. recessions as identified by theNational Bureau of Economic Research.
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Authors’ calculations based on data from Haver Analytics.
index
OLS minus CFNAIHR minus CFNAIAR minus CFNAI196772778287929720020712−1.0−0.50.00.51.01.5
The
uneven recovery rom the Great Recession has led some observers to ques-tion whether the growth potential o theU.S. economy declined in its atermath.To address this important question,economists need to beable to dierentiatebetween movementsin the trend compo-nent o economicgrowth and those inthe cyclical compo-nent. The cyclicalcomponent capturesmedium-run actorsdriving economicgrowth and is generally associated with thebusiness cycle—theperiodic uctuationsin economic activity around its long-termhistorical trend. Incontrast, the trendcomponent captureslong-run actors, suchas potential growthin productivity, capi-tal, and labor. In this
Chicago Fed Letter 
, wedetail a new way or constructing theCFNAI that makes it possible to simul-taneously link the estimation o themonthly CFNAI to quarterly real GDPgrowth and decompose it into its trendand cyclical components. At least someo the weakness in real GDP growth dur-ing the recovery can be attributed to adecline in its trend (or average) rate o growth, although cyclical actors are shownto have played a more dominant role.
CFNAI and DF-CFNAI
The CFNAI is a monthly index o U.S.economic activity constructed rom 85data series (or indicators) classifed intoour groups: production and income;employment, unemployment, and hours;personal consumption and housing;and sales, orders, and inventories.
Theindex is normalized to reect deviationsaround a trend rate o economic growth. As such, a zero value or the index indi-cates that growth in economic activity is proceeding along its long-term histori-cal path, a negative value indicates below-average growth, and a positive valueindicates above-average growth.Essentially, the CFNAI is a weightedaverage o the 85 data series, with theirindividual weights representing the rel-ative degree to which each series explainsthe total variation among all the series.The statistical method used to generatethese weights is called principal com-ponents analysis, or PCA. The CFNAIis the frst principal component o the85 data series, as it is the single actorcommon to each data series that ex-plains the most variation across all 85.To construct our alternative CFNAI, wereweight the underlying data series to
 
2. Fraction of data variance explained
DF-CFNAICFNAI OLS HR AR
Total 0.29 0.29 0.28 0.27Production and income 0.38 0.38 0.46 0.55Employment, unemployment,and hours 0.36 0.36 0.33 0.27Personal consumptionand housing 0.08 0.08 0.05 0.02Sales, orders, and inventories 0.17 0.17 0.16 0.15
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The figure displays the fraction of the variance of the 85 underlying indicators in theCFNAI and the three variants of the DF-CFNAI (see the text for details on OLS, HR, and AR)that is explained by each index (see top row). In addition, it decomposes this fraction into theshare explained by each of the four broad categories of indicators listed here. The values forthe categories’ shares may not sum to one because of rounding.
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Authors’ calculations based on data from Haver Analytics.
3. RMSE ratios for current quarter GDP growth forecasts
DF-CFNAIOLS HR AR
1967–2012 0.91* 0.93* 0.93*1985–2012 0.91* 0.92* 0.92*1967–76 0.89* 0.92* 0.931977–86 0.90* 0.94* 0.94*1987–96 0.92* 0.97 0.971997–2006 0.89* 0.90* 0.91*2007–12 0.95* 0.91* 0.92*
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The figure displays root mean squared error (RMSE) ratios for current quarter realgross domestic product (GDP) growth forecasts based on the three variants of the DF-CFNAI(see the text for details on OLS, HR, and AR). A value less than one indicates a forecastbased on the DF-CFNAI for the sample period labeled in each row is more accurate thana similar forecast based on the CFNAI (more precisely, the lower the value, the moreaccurate the DF-CFNAI’s forecast). All of the forecasts based on the DF-CFNAI include atime-varying mean for real GDP growth, in contrast to those based on the CFNAI, whichinstead allow for discrete shifts in the mean of real GDP growth as explained in the text.Ratios with * denote statistical significance at the 95% confidence level according to theDiebold–Mariano mean squared error test statistic for equal forecast accuracy.
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Authors’ calculations based on data from Haver Analytics.
instead isolate the single actor that explains the most variation in the 85 dataseries and real GDP growth, as well asbest describes their historical evolution.This alternative estimation procedureor the underlying series’ weights resultsin the construction o what is reerredto as a dynamic actor.
The dierences between the CFNAI andthe index that results rom our alter-native estimation procedure—which we call the DF-CFNAI—tend to be very small unless we also relax some o theadditional assumptions o PCA. Figure (on ront page) plots the dierencesbetween the CFNAI and three variantso the DF-CFNAI rom January 967through March 0 ater each index was transormed into a three-month mov-ing average. With this construction, weget a more consistent picture o nationaleconomic growththan that shown by the monthly indexes, which can vary signif-cantly rom month tomonth. The three-month moving averagealso has the advantageo highlighting themedium-run move-ments that are typicalo the business cycle,captured in fgure by the shaded periodscorresponding withU.S. recessions asidentiied by theNational Bureau o Economic Research.The dierences be-tween the indexesthat do exist appeararound several busi-ness cycle turningpoints and, most no-tably, during the re-covery rom the mosrecent recession.The two assumptionso PCA that we relaxin fgure  aect the way the weights arecalculated by assigningless o the variance o the individual indicators to the com-mon actor and more to idiosyncraticshocks. The frst assumption that werelax—the result o which we reer toas HR in fgure —is that an individualindicator cannot be subject to idiosyn-cratic shocks that are more volatile thansimilar shocks or other indicators.
Thesecond assumption that we relax is that idiosyncratic shocks or each indicatorare not persistent. The result o relaxingboth assumptions is reerred to as AR in fgure . Neither PCA assumption isrelaxed or the DF-CFNAI variant reerredto as OLS in fgure . In this case, thesmall dierences between the CFNAIand OLS stem entirely rom our alter-native estimation procedure.The recent experience o the hous-ing market is inconsistent with bothassumptions, in that the protracted re-covery o the housing indicators impliesthat they experienced idiosyncratic shocksthat were more volatile and persistent than those experienced by other indi-cators. The DF-CFNAI puts relatively less weight on the housing indicators thandoes the CFNAI as a result. However,the housing indicators in the CFNAIare not the only indicators inconsistent  with these assumptions—and such in-consistency is not solely confned to therecent period. Similar to what we oundin previous work examining potentialtrends in the CFNAI’s 85 underlying in-dicators, the contributions to the indexrom two other categories o indicators—the employment, unemployment, andhours category and the sales, orders, andinventories category—are also aectedby these assumptions.
4
Figure  decomposes the overall varianceexplained by the CFNAI and the three variants o the DF-CFNAI into the con-tributions rom their our groups o in-dicators. Compared with the CFNAI, theHR and AR variants o the DF-CFNAIcapture a much larger share o theoverall variance in the production andincome category at the expense o theother three categories o indicators. It is also the case that these two variantso the DF-CFNAI capture slightly less o the
total 
variance o the 85 underlyingdata series than the CFNAI. The latterfnding suggests that the HR and AR  variants o the DF-CFNAI are normal-ized at slightly dierent average levelsthan the CFNAI. This fnding, then,also has implications or the trend rateo economic growth.
Trend rate of economic growth
In previous work, we documented how the three-month moving average o the CFNAI—the CFNAI-MA—can beused to generate current quarter ore-casts o real GDP growth.
5
Values o theCFNAI-MA that were above zero in therecent past have historically been asso-ciated with above-average current quarterreal GDP growth. This is also true orthe three-month moving average o theDF-CFNAI. Because DF-CFNAI valuesduring much o the recent recovery havebeen systematically higher than CFNAI
 
Charles L. Evans,
President 
;
 
Daniel G. Sullivan,
 Executive Vice President and Director o Research 
;
 
Spencer Krane,
Senior Vice President and Economic Advisor 
;
 
David Marshall,
Senior Vice President 
,
fnancial markets group 
;
 
Daniel Aaronson,
Vice President 
,
 microeconomic policy research 
;
 
 Jonas D. M. Fisher,
 Vice President 
,
macroeconomic policy research 
;
 
RichardHeckinger,
Vice President 
,
markets team 
;
 
 Anna L.Paulson,
Vice President 
,
fnance team 
;
 
 William A. Testa,
Vice President 
,
regional programs 
,
and Economics Editor 
;
 
Helen O’D. Koshy and Han Y. Choi,
Editors 
;
 
Rita Molloy and Julia Baker,
Production Editors 
;
 
Sheila A. Mangler,
Editorial Assistant.Chicago Fed Letter 
is published by the EconomicResearch Department o the Federal Reserve Banko Chicago. The views expressed are the authors’and do not necessarily reect the views o theFederal Reserve Bank o Chicago or the FederalReserve System.© 0 Federal Reserve Bank o Chicago
Chicago Fed Letter 
articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed or commercial gainand provided the source is appropriately credited.Prior written permission must be obtained orany other reproduction, distribution, republica-tion, or creation o derivative works o 
Chicago Fed Letter 
articles. To request permission, please contact Helen Koshy, senior editor, at --580 oremail Helen.Koshy@chi.rb.org.
Chicago Fed Letter 
and other Bank publications are availableat www.chicagoed.org.
 
ISSN 0895-064
4. Estimates of the trend rate of economic growth
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The figure displays estimates of the time-varying mean of real gross domestic product(GDP) growth based on the three variants of the DF-CFNAI (see the text for details on OLS,HR, and AR) from 1967:Q1 through 2012:Q4. For comparison, the Congressional BudgetOffice’s (CBO) estimate of growth in potential real GDP for the U.S. is also presented.
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Authors’ calculations based on data from Haver Analytics.
percent growth on an annualized basis
1967 ’72 77 82 87 92 97 2002 07 121.02.03.04.05.0ARHROLSCBO
 values (shown in fgure ), this suggestsreal GDP growth that is even urtherabove average. How do we reconcile this with the act that real GDP growth hasbeen much weaker on average during therecent recovery than during the recov-eries rom previous deep recessions? Oneinterpretation is that average (or trend)real GDP growth is now much lower andhas been declining during the recovery.Our alternative estimation rameworkmakes it possible to quantiy this possibility by decomposing real GDP growth intoits cyclical and trend components in theprocess o estimating the DF-CFNAI. Todo so, we use a “nowcasting” equation(similar to the one used in Brave andButters, 00), which relates current quarter real GDP growth to current andpast values o the three-month movingaverage o the DF-CFNAI. In this way, we both control or the cyclical dynamicso real GDP growth using the DF-CFNAIand allow current quarter real GDPgrowth to shape the DF-CFNAI’s recent history. Here, however, to capture thetrend component we also include a time- varying mean or real GDP growth, whichdistinguishes this exercise rom Braveand Butters (00) where we insteadconsidered several discrete shits in themean o real GDP growth over time.
6
  We use the DF-CFNAI to control orthe cyclical component o real GDPgrowth because, likethe CFNAI, it can beshown to be an excel-lent coincident indi-cator o the businesscycle. Using the meth-od developed by Bergeand Jordà
7
to quantiy the accuracy o ourindexes in capturingU.S. recessions andexpansions since 967, we fnd that the HR and AR variants o the DF-CFNAI are both95% accurate, whilethe OLS variant andCFNAI are 94% accu-rate. So, by this mea-sure, the HR and AR variants o theDF-CFNAI are only slightly more accurate in identiying U.S.recessions and expansions than the OLS variant and the CFNAI, with the dier-ence not being statistically signifcant.Figure  presents root mean squarederror (RMSE) ratios computed usingcurrent quarter orecasts o real GDPgrowth based on the CFNAI and thethree variants o the DF-CFNAI. For theCFNAI’s orecasts, we allow or discreteshits in the mean o real GDP growthover time as in Brave and Butters (00).In contrast, the DF-CFNAI’s orecastsare based on a time-varying mean orreal GDP growth. A value less than onein fgure  indicates in each instancethat the DF-CFNAI’s orecasts are moreaccurate than the CFNAI’s (more pre-cisely, the lower the value, the moreaccurate the DF-CFNAI’s orecasts).
8
 There is some variation in the level o accuracy across the DF-CFNAI variants’orecasts depending on the time period.In general, the OLS variant’s orecastsdominate those o the other two. Morerecently, however, the HR and AR models have produced slightly superiororecasts, but not enough to be statisti-cally signifcantly dierent rom theOLS model’s.Figure 4 plots the history o our esti-mates o the time-varying mean o realGDP growth based on the DF-CFNAIover the period 967:Q–0:Q4. Forcomparison, we also include in fgure 4the Congressional Budget Ofce’s (CBO)estimate o growth in potential real GDP.The CBO’s estimate o potential real GDPgrowth is calculated in a vastly dierent  way than our estimate o the time-varyingmean o real GDP growth, but it too aimsto capture a similar notion o the long-run growth trend.
9
Our HR and AR esti-mates o the time-varying mean o realGDP growth are highly correlated withthe CBO’s estimate o potential growthand have an average absolute deviationo 0. percentage points rom it in thepost-984 era. That said, all our esti-mates have very dierent interpretationso recent history. The HR and AR growthestimates exhibit declines o about 0.5 per-centage points and 0.7 percentage pointssince 007, respectively; and the OLSgrowth estimate ell by roughly 0. per-centage points since then, while the CBO’sestimate o potential growth decreasedby 0.6 percentage points.
Conclusion
Our estimates o the trend rate o eco-nomic growth show that it has uctuatedconsiderably over time, alling romaround 4.5% in 967:Q to .5%–.5%by the end o 007. Its urther decline

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