Forecast of Macroeconomic Variables in the USA

Including Uncertainties and Instabilities in

Factorial Models
Rafael B. Barbosa

Economics Professor at the Ceará Federal University (UFC/DEA)

Thibério Mota da Silva

Substitute Economics Professor at the Ceará Federal Univesity (CAEN/UFC)

Roberto T. Ferreira

Economics Professor at the Ceará Federal University (UFC/CAEN/DEA)

[VERSAO SET/17]

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1. Introduction

Factorial models extract a small number of factors based on a large data set, which is later
on used for forecasting purposes. Stock and Watson (2002, 2008, 2012) show that factorial models
can generate more ecient forecasts than standard time series and structural models, and can be
normally used to predict macroeconomic variables1 . Although the quality in forecast economics
variables structural breaks and other instabilities documented in these time series2 may cause
forecasting errors, as demonstrated for example by Clements and Hendry (1999) and Pesaran and
Timmermann (2002). In these cases, the forecasting models may present some uncertainties with
regards to the correct functional form and the instability of estimated parameters.
A recently proposed way to include instabilities in forecasting model parameters is by
applying the Dynamic Model Average (DMA) introduced by Raftery et al (2010)3 . The DMA
combines dierent models through time using bayesian weights and time-variable parameters.
Koop and Korobilis (2012), Baur, Beckmann and Czudaj (2014) and Beckmann and Rainer (2016),
showed that the DMA has moderate success in forecasting economic variables.
Meanwhile, the DMA is a computationally intensive method that is dicult to use in
applications with many potential forecasters. For example, in order to forecast the quarterly
ination in the US, Koop and Korobilisis (2012) applied the DMA using only fteen variables.
Thus the use of DMA in large datasets is not recommended, which implies the exclusion of several
potential macroeconomic forecasters that may contain important information on the future of the
target variable.
This article proposes a way to forecast macroeconomic variables by using factor models
combined through DMA algorithm. We called these forecasts as DI-DMA. DI-DMA use of factorial
analysis to reduce the dimension of a large data set for a reduced number of factors used in
a forecasting equation estimated through the DMA4 . This method simultaneously considers the
possibility of structural changes in variables and the uncertainty on the correct forecasting equation
specication.
Thereby, we incorporate the uncertainty on which factor is the most relevant to predict
the target variable and which its weight is on the forecasting equation for each period of time.
Alternative ways of introduction DMA in a large data set has been proposed. Onorante and
Raftery (2016) proposed a method to use the DMA in large databases. Koop and Korobilis (2011)
introduced a means to include blocks of factors through the DMA.
The principal component method is a unsupervised method of estimation. There are
recent evidence that pre-treateament of the data before extract the factors yields gains of predictive
power (BOIVIN and NG (2006), TU and LEE (2013), BAIR et al (2006)). Therefore, the predictive
performance of three alternative factor estimation ways in the DI-DMA is also evaluated: i. factors
are estimated through previously selected variables applying the Lasso method (Least Absolute
Selector and Shrinkage Operator); ii. selected variables through the LARS algorithm (Least Angle
Regression), both as in Bai and Ng (2008) and, iii. it use Combining Forecasts using Principal
Components (CFPC) supervision method developed by Tu and Lee (2013).
1 Several other authors corroborated the predictive eciency of factorial models: Bai and Ng (2003), Artis et
al (2005), Ferreira, Bierens and Castelar (2005), Kapetanios and Camba-Mendez (2005), Bai and Ng (2008), Dias,
Pinheiro and Rua (2010), Kapetanios et al (2011), Marcellino et al (2015), among others.
2 See Rossi (2012) and Stock and Watson (2008)
3 There are other approaches to include instabilities and uncertainty in forecast models, see Rossi (2012) for a
review.
4 Koop and Potter (2004) and Kim and Swanson (2014) showed that Bayesian weighting may improve forecasts
generated by factorial models.

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 The DI-DMA does not separate variables in groups to estimate factors, as in Koop and
Korobilis (2011), and it doesn't perform an a priori selection of the forecasting equation. Once
estimated, factors forecasts are dynamically combined through the bayesian probability method,
dierent from other studies that also use static bayesian weighting applied to factorial models
such as the case of Koop and Potter (2004), Kim and Swanson (2014) and Cheng and Hansen
(2015). Forecasts with little predictive power shall have a lower weight than those with better
performance through time. Therefore, the DI-DMA does not require any a priori selection of
forecasting equations. An estimated factor may be excluded from the forecasting equation only
if it receives a zero weight, in compliance with the regularization role of the bayesian weighting
(Hastie et al, 2009).
The procedure proposed can be thought as a forecasting model selection, dierent than the
traditional approach in which factors that compose the forecasting equation are selected through
information criteria such as BIC and AIC. Bai and Ng (2008) argue that such information criteria
procedure is inadequate, as factors don't have a natural order among one another.
The predictive eciency of the DI-DMA is evaluated through Monte Carlo simulations and
through an empirical exercise to forecast six US macroeconomic variables. The US variable include
real and nominal variables as producer and consumer price indexes (PPI and CPI); industrial
production index (IP), current money (M2), house starts (Hous) and unemployment rate (Unrate).
Factors are estimated through a database containing 115 macroeconomic variables with monthly
frequency5 . Forecasts developed with the proposed techniques are compared to those of other
methods recognized in empirical literature as good forecasters for these macroeconomic variables
using factor models.
Among the results obtained, we verify that the DI-DMA simulations resulted in more
ecient forecasts than those of standard factor models. This result is more evident as more
variability and/or uncertainty are added to the simulations. With regards to the empirical exercise
results, mean square prediction errors of forecasts (MSPEF) of the DI-DMA model are smaller than
those of other models in most variables and forecasting horizons. Considering all variables, the
DI-DMA or one of its versions yields the small mean squared error of forecast in more than 80%
of cases.
Besides this introduction, this paper is divided into the following sections: section two
formally introduces the DI-DMA forecast approach. In the same section, we discuss how factors
are estimated and how they can be dynamically combined. We also discuss DI-DMA extensions.
In section three, simulation exercises for three dierent DGP's are introduced. Section four intro-
duces results for the six macroeconomic variables considered. Finally, section ve draws the main
conclusions.

2. Factor models and DMA

Let´s considerXit a panel in which i = 1, ..., N corresponds to N variables and t = 1, ..., T

the period of time. The factor model assumes that Xit may be represented by:

Xit = λ0i Ft + eit (1)

WhereFt are called factors; λi are the load factors and eit ∼ N (0, σ ) is the approximation
2

error of Xit by λ0i Ft . The hypothesis that Xit possesses a factorial structure implies that the
5 Data was obtained from the Federal Reserve of St. Louis (FRED) database. Please refer to the appendix for
further details.

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dimension of Xit may be reduced to r  N factors in which each factor represents a part of the
Xit .
Factors are estimated through the principal components method6 (PCM). Consider as
a matrix of estimated factors T times to autovectors associated to the highest r eigenvalues of
matrix XX ´ of order (T xT ). Once estimated, factors are usually used in a forecasting equation
that may include a set of exogenous variables, such as dependent variable osets. Considering yt
as the variable to be forecasted h periods ahead with the information set until t, which means
that yt+h|t , Wt a set of exogenous variables are normally represented by the lags of yt , β(L) and
α(L)polynomials of osets for F̂ and W ,respectively. The forecasting equation is then given by:

yt+h|t = β(L)F̂t + α(L)Wt + εt (2)

2.1 Dynamic Model Average (DMA)

The DMA is a method originally developed by Raftery et al (2010) and later applied to
economic data as explained by Koop and Korobilis (2011. 2012) and Beckmann and Schussler
(2016), among others. This method allows combining forecasts in which both parameters and
variables that compose the equation (2) are modied through time. Seeking to describe DMA, if
xt is a vector with N regressors, there are 2N = k possible models to forecast yt formed by the
combinations among these variables. If yt+h|t
(k)
is the forecast of yt for h periods ahead considering
the information set in t then the k − th model that uses the subset of variables is given by x(k)
t of
xt . Raftery et al (2010) propose to generate these predictions through:
(k)
yt+h|t = xt βt
(k) (k) (k)
+ t (3)

βt
(k) (k)
= βt−1 + ηt
(k)
(4)
Equation (3) is the space equation and equation (4) is called state equation. To combine
these k models it is necessary to consider the dynamic weight of each model through time. Without
loss of generality, let's consider k = 1 and h = 1. In this case:
yt+1|t = βt xt + t (5)

βt = βt−1 + ηt (6)
In which, t ∼ N (0, σt2 ), ηt ∼ N (0, σηt
2
) and t and ηt are not correlated. Raftery
et al (2010) used the Kalman
 lter to estimate this model. Consider the following transition
0 0 
equations: Pt|t−1 = E t − t|t−1 t − t|t−1 , Pt|t = E t − t|t t − t|t and Gt|t−1 =
  

 0 
. The term in which t|t−1 is the forecast error in t using information

E yt − yt|t−1 yt − yt|t−1
until t − 1. Likewise, yt|t−1 prediction of yt considering the set of information in t − 1. As t has a
normal distribution, then βt|t−1 ∼ N (β̂t−1 , Pt|t−1 ), where,

Pt|t−1 = Pt−1|t−1 + σηt (7)

6 For
further details on the factor estimation process please see Stock and Watson (2002), Bai and Ng (2002) and
Bai (2003).

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 Raftery et al (2010) proposed a computationally simpler way to calculate (7), without
having to use methods such as the Markov Chain Monte Carlo (MCMC) which is more computa-
tionally intensive. The author's suggestion is to consider σηt = (γ −1 − 1) Pt−1|t−1 , in which γ is a
forgetting factor.This way, the previous equation may be expressed by:
1
Pt|t−1 = Pt−1|t−1 (8)
γ
If we assume that 0 < γ ≤ 1then the forgetting factor suggests a weighing of observations
that compose Pt|t−1 . This means that the j-eth observation shall receive a weight γ j . For instance,
supposing that the database frequency is monthly, then the observation of ve years ago considering
a γ = 0.99,shall receive only 55% of the weight7 on Pt|t−1 . Therefore, a second advantage of
this specication is the exponential weighing of observations that produce forecasts based on
observations with higher weight in the present or in the past, depending on the parameter choice
and checking for possible instabilities in model parameters. The forecast is completed through the
Kalman lter update equation given by:

βt|t ∼ N (β̂t , Pt|t ) (9)

Where,

β̂t = β̂t−1 + Pt|t−1 xt Ht−1 (yt − xt β̂t−1 ) (10)

and

Pt|t = Pt|t−1 − Pt|t−1 xt Ht−1 xt Pt|t−1 (11)

In which Ht = . The forecast is performed recursively and updated for each
σt + xt Pt|t−1 x0t
period through equations (10) and (11). Therefore, yt|t−1 ∼ N (xt β̂t−1 , Ht ).The same procedure is
applied when we have several models. In the case of the system formed in (3) and (4), consider Θt as
the vector of all possible k coecients in t time, which means that Θt = (βt(1) , ..., βt(k) ). The DMA
seeks to attribute weight to each forecast E(yt(k) |yt−1 ) in a time t conditional to the information
already observed in the behavior of the target variable in time t − 1.
Consider that each forecast receives a probability of p(Lt = k|yt−s )for each period tIn other
words, this is the probability for a model in a time t of being k conditional to the occurrence of yt−s
or, in a more general way, the probability of the model Mti , i = 1, ..., k and t = 1, ..., T , conditional
to the information set It−1 ,which means that P (Lt = k|yt−s ) = P (Mti |It−s ). The DMA, generates
a forecast weighted by all possible models with the weight given by p(Lt = k|yt−s ) and applying a
recursive estimation scheme.
K
(i) (i)
(12)
X
E(yt |yt−1 ) = p(Mti |It−1 ) xt β̂t
i=1
Seeking to determine p(Mti |It−1 ),Raftery et al (2010) proposed a Bayesian procedure that
depends on a forgetting α,
P (Mit |It−1 )α
P (Mit |It−1 ) = J
(13)
α
X
P (Mjt |It−1 )
j=1

7 In ve years or 60 months ago, therefore, 0.9 9^60=0.5471.

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 The model weighing update is carried out though the Bayes Rule,
p(yt |Mti , It−1 )P (Mti |It−1 )
P (Mit |It−1 ) = PJ
j=1 p(yt |Mj , It−1 )P (Mjt |It−1 )

Where p(yt |Mti , It−1 ) is the predictive density of model i. . The equation may be written
as:

P (Mti |It−1 ) ∝ [P (Mti |It−2 )p(yt−2 |Mti , It−2 )]α (14)

t−1
s
p(ys |Mti , It−s−1 )α
Y
=
s=1

The weighting means proposed by Raftery et al (2010) has the advantage of not requiring
a transition matrix between each of the models through time, which would be computationally
infeasible if the number of models is suciently large. Therefore, models that foresaw well in the
past receive more weight in today's forecasts. The notion of the past depends on the forgetting α.
This one attributes an exponential weighting to the past, in the same way it does to the forgetting
γ . Observe that if α = 1, then the weighting form starts to obey only the update performed
through the Bayes rule, therefore generating a weighted Bayesian forecast (BMA). On the other
hand, if α = 0, , then the weighting attributes equal weight to all models, being therefore a model
with even weighting. The DMA, in turn, assumes that 0 < α ≤ 1.The size of the exponential
window will depend on the data frequency and the choice of α.The choice recommended by Koop
and Korobilis (2012) and by Raftery et al (2010) is α = {0.95; 0.99}.
Koop and Korobilis (2011) proposed to estimate a single factor for each group of variables
(such as price indexes variables, real variables, nancial variables, etc) and combine them through
the DMA. The reasons to adopt this estimation through sets of variables enable the economic
interpretation of factor behavior for a yt forecast through time. However, in dierent applications8
other factors are more relevant in terms of predictive content than just the rst factor. In the
present work, we didn't make and ad-hoc a priori choice of variables. In the DI-DMA models, up
to k factors are estimated through PC without an initial variable grouping, as afterwards they are
dynamically combined by the DMA.

2.3 Extensions
Bair et al (2006) and Boivin e Ng (2006) showed that variable selection methods through
the analysis of the correlation among prediction target variables and those variables contained in
the database can improve the predictive eciency of factor models. According to Bai and Ng
(2008) the selection of variables denominated target predictors is developed through methods with
hard and soft thresholds. In the rst case, variables are selected through information criteria such
as Akaike (AIC) and Baysiano (BIC). In the second case, regularization methods such as LASSO
(Least Absolute Selector and Shrinkage Operator) and LAR (Least Angle Regression)9 are applied
to previously selected variables. Another method used for this procedure is the supervised factor
(Hastie et al, 2012). In the supervision technique proposed by Tu and Lee (2014), factors are
8 See Stock and Watson (2002, 2012), Ng and Ludvigson (2008), Bai and Ng (2008) among others.
9 The Lasso method was originally proposed by Tibsharani (1996) and the Lar method was developed by Efron
et al (2002).

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obtained from a transformed database resulting from the inuence estimation of each variable
contained in X_it on the target prediction variable. This method is called Combining Forecasts
of Principal Components (CFPC)
Supervised versions of DI-DMA are also analyzed in this study. The supervision is car-
ried out through the LASSO, LAR and CFPC methods. The goal is to verify if the prediction
power can be improved by employing this type of factor supervision, obtained through the previ-
ous reduction of the number of observations contained in Xit or through the extraction of factors
from a transformed database. In the LASSO case, variables are selected through the following
minimization problem:
T
(yt − βXit )2 + π |β|
X

t=1

Whereβ is a coecient vector to be estimated, of size N × 1, π is called tuning parameter

N
and measures the selection sensitivity and |β| = βi . The tuning parameter is selected through
X

i=1
crossed validation. The LASSO method selects variables by attributing an estimated coecient
equal to zero to irrelevant variables.
The LAR is a selection method similar to the Forward Stepwise Regression10 .Firstly, the
variables are ordered according to their predictive power. Later on, a parsimonious forecasting
model is selected among the top ranked variables. In comparison to other selection methods, the
LAR is considered to be computationally more ecient than the LASSO. The LAR algorithm is
fast and boasts accurate predictions in dierent data structures11 .
Finally, in the CFPC method, a regression is developed for each of the variables contained
inXit for the target variable yt , This is used to predict the target variable ŷi, t+h|t for each period
outside the sample. Factors are extracted from this set of forecasts. This way, we have four possible
specications for the DMA applying factors: the non-supervised specication, as introduced in 2.1
(DI-DMA) and the specications supervised with the LASSO (DI-DMA-LASSO), LAR (DI-DMA-
LAR) and CFPC (DI-DMA-CFPC).

3.Simulation

In this section we introduce the Monte Carlo exercises. Three dierent data generation
processes (DGP) based on the Monte Carlo exercise developed by Bai and Ng (2009) are used.For
the rst DGP (DGP-1) consider j = 1, ..., r and the following data generation equations:
0 √
xit = λi Ft + reit
Fjt = αj Fjt−1 + ujt
eit = ρi eit−1 + σe it

Where, i = 1, ..., N e t = 1, ..., T ; αj ∼ U [0.2, 0.8], ρ ∼ U [0.3, 0.8]; λi ∼ 0.5N (0, r). These
parameters follow the same probability distributions during the entire simulation process. The
forecast equation for a period ahead is:
10 The Forward Stepwise Regression builds a model through the addition of new variables for each estimation
process. After that, each new set of variables is used to perform the forecast.
11 See Efron et al (2004), Boveslstad et al (2007), Saigo et al (2007) and Gelper and Croux (2008) for more details

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 yt+1 = β1 F1t + β2 F3t−4 + β3 F6t2 + vt+1

The parameters are xed and dened by β = (0.8, 0.5, 0.3). The shocks ujt , it and
vt+1 are normally distributed with a mean equal to zero and a variance equal to one. Notice that
as σe becomes smaller, the importance of factors to explain the variability of the set of variables
increases. Three dierent scenarios are considered for σe = (0.1, 0.8, 1.5).
The second DGP (DGP-2) generates the set of variables xit similar to the DGP-1. However,
the forecasting equation shall be:

yt+1 = β1 F2t + β2 F2t−1 + β3 F2t−2 + β4 F4t−1 + β5 F4t−2 + σv vt+1

In which, β = (0.8, 0.5, 0.2, 0.4, 0.4) and σv = 1. Finally, in the third DGP (DGP-3) there
is uncertainty with regards to the correct functional form and instability (structural change) in the
forecasting equation parameters. For this reason, the vector of parameters β of DGP-2 is altered,
so that βt≤τ = (0.8, 0.5, 0.2, 0.4, 0.4) and βt>τ = (0.8, 0, 1.2, 0.4, 0.4), where τ represents the time
of change in the functional form. . When the second parameter is equal to zero the functional form
stops containing ve variables to include only four of them, which characterizes the uncertainty of
the prediction equation functional form. Besides, the third parameter has increased in one unit.
Finally, σv = 1.1contrary to what happens in DGP-2.
We assume that N = T = 100 and that the number of simulations is B = 5000. For
each simulation, the xit factors are extracted and then combined through the DMA to generate
the forecast for a period ahead yt+1 . The models DI-DMA are estimated assuming that forgetting
parameters are equal to 0.95.Forecasts for these models are then compared to those of other predic-
tion methods that use variable selection factors and procedures: the Mallows criterion (MMA), the
Leave-one-out (LHO) criterion, developed by Cheng and Hansen (2015) and the Bayesian weigh-
ting (BMA) 12 . The predictions are evaluated through three statistics: mean square prediction
error (MSPE), mean square prediction error ratio related to the DI (MSPER) model and mean
square prediction error ratio related to the yt variance (MSPEV).
Tables 1 to 3 introduce results for the three DGP's, respectively. For eachσe there are
three lines associated to each forecasting model. The rst line corresponds to the MSPE. The
second expresses the MSPE related to the yt variance. Finally, the third one refers to the MSPE
related to the DI MSPE model.
Results demonstrate that DI-DMA models show smaller prediction error levels (MSPE,
MSPER and MSPEV), with regards to the comparison models. Besides, it is veried that a higher
database variability aects predictions of models that don´t use the DI-DMA method. According
to Tables 1 and 2, the dierence between the DI and the DI-DMA becomes higher as the weight
of factors on Xit is reduced and that dierence is bigger in the DGP-2, with DI-DMA predictions
that are on average, 7.4 % more accurate than those of the DI. Table 3 introduces results for the
DGP-3, in which there is uncertainty on the functional form and on parameter instability. In this
case, the gain in terms of DI-DMA predictive eciency compared to the DI models is higher than
in the previous cases. The DI-DMA is on average, 18% more accurate than the DI models.
12 Here, the empirical BMA obtained by assuming that DMA forgetting factors are equal to 1.

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 The comparison between the predictive eciency of the DI-DMA with regards to other
variable selection techniques applied with estimated factors presents similar results. The biggest
dierence among these techniques occurs in the DGP 3, with DI-DMA predictions averaging 5.8%;
3.49% and 3.77% more eciency than those performed with the BMA, MMA and LHO models
respectively.

Tabela 1: DGP-1
DI-DMA DI-DMA DI-DMA
σe DI-DMA BMA MMA LHO
LASSO LAR CPFC
0.1 0,0333 0,0335 0,0334 0,0329 0,0344 0,0336 0,0338
1,0562 1,0557 1,0555 1,0486 1,0692 1,0671 1,0694
0,9940 1,000 0,9970 0,9820 1,0268 1,0029 1,0089

0.8 0,0337 0,0334 0,0333 0,0333 0,0353 0,0362 0,0363

1,0925 1,0866 1,0865 1,0873 1,1082 1,1264 1,1293
0,9466 0,9382 0,9353 0,9353 0,9915 1,0168 1,0196

1.5 0,0340 0,0334 0,0333 0,0335 0,0359 0,0363 0,0364

1,0954 1,0858 1,0856 1,0889 1,1181 1,1275 1,1302
0,9523 0,9355 0,9327 0,9383 1,0056 1,0168 1,0196
NOTE :Table 1 introduces results of the Monte Carlo simulation exercise for the DGP-1. Seven models are estimated for dierent
variance parameters for generated variance residuals considering four dierent versions for the DI-DMA: non supervised (DI-DMA)
with variable selection performed through the LASSO (DI-DMA-LASSO), the LAR (DI-DMA-LAR) and the CFPC (DI-DMA-CFPC).
The last three columns show results obtained by using the Bayesian Criterion, the Mallows (MMA) and Leave-one-out (LHO). methods.
The rst line of each σe represents the mean square prediction error (MSPE). The second line introduces the MSPE ratio for each model
with regards to the yt variance. Finally, the third line expresses the MSPE ratio for each model with regards to the MSPE for the DI
model.

Tabela 2: DGP-2
σe DI-DMA DI-DMA DI-DMA
DI-DMA BMA MMA LHO
LASSO LAR CPFC
0.1 0,0328 0,0324 0,0322 0,0333 0,0352 0,0344 0,0345
1,0699 1,0582 1,0581 1,0661 1,0992 1,0849 1,0847
0,9371 0,9257 0,9200 0,9514 1,0057 0,9828 0,9857

0.8 0,0324 0,0322 0,0321 0,0333 0,0359 0,0344 0,0345

1,0644 1,0565 1,0564 1,0669 1,0976 1,0854 1,0851
0,9257 0,9200 0,9171 0,9514 1,0257 0,9828 0,9857

1.5 0,0322 0,0323 0,0322 0,0332 0,0356 0,0345 0,0346

1,0627 1,0579 1,0578 1,0644 1,0982 1,0864 1,0861
0,9147 0,9176 0,9147 0,9431 1,0113 0,9801 0,9829
NOTE: Table 2 introduces results of the Monte Carlo simulation exercise for the DGP-2. Seven models are estimated for dierent
variance parameters for generated variance residuals considering four dierent versions for the DI-DMA: non supervised (DI-DMA)
with variable selection performed through the LASSO (DI-DMA-LASSO), the LAR (DI-DMA-LAR) and the CFPC (DI-DMA-CFPC).
The last three columns show results obtained by using the Bayesian Criterion, the Mallows (MMA) and Leave-one-out (LHO). methods.
The rst line of each σe represents the mean square prediction error (MSPE). The second line introduces the MSPE ratio for each model
with regards to the yt variance. Finally, the third line expresses the MSPE ratio for each model with regards to the MSPE for the DI
model.

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 Tabela 3: DGP-3
σe DI-DMA DI-DMA DI-DMA
DI-DMA BMA MMA LHO
LASSO LAR CPFC
0.1 0,989 0,989 0,989 0,989 1,064 1,062 1,055
1.279 1.279 1.279 1.279 1.278 1.298 1.291
0,8047 0,8047 0,8047 0,8047 0,8657 0,8641 0,8584

0.8 1,002 1,002 1,002 1,002 1,034 1,034 1,067

1.283 1.283 1.283 1.283 1.276 1.276 1.291
0,8119 0,8119 0,8119 0,8119 0,8379 0,8379 0,8646

1.5 0.998 0.998 0.998 0.998 1.044 1.044 1.039

1.275 1.275 1.275 1.275 1.279 1.279 1.279
0,8471 0,8471 0,8471 0,8471 0,8862 0,8862 0,8820
NOTE: Table 3 introduces results of the Monte Carlo simulation exercise for the DGP-3. Seven models are estimated for dierent
variance parameters for generated variance residuals considering four dierent versions for the DI-DMA: non supervised (DI-DMA)
with variable selection performed through the LASSO (DI-DMA-LASSO), the LAR (DI-DMA-LAR) and the CFPC (DI-DMA-CFPC).
The last three columns show results obtained by using the Bayesian Criterion, the Mallows (MMA) and Leave-one-out (LHO). methods.
The rst line of each σe represents the mean square prediction error (MSPE). The second line introduces the MSPE ratio for each model
with regards to the yt variance. Finally, the third line expresses the MSPE ratio for each model with regards to the MSPE for the DI
model.

4. Forecast macroeconomic variables with DI-DMA

In this section, we analyze the DI-DMA empirical results for six USA macroeconomic
variables: producer price index (PPI), consumer price index (CPI); industrial production index
(IP), M2. house starts (Hous) and unemployment rate (Unrate). Factors are estimated from a
database containing 115 macroeconomic variables with a monthly frequency between 1963.1 until
2015.1213 . The in-sample starts in 1963.1 and ends in 1972.12. The out-of-sample or evaluation
sample starts in 1973.1 and nishes in 2015.12.
The database is extracted from the FRED and covers several macroeconomic variable
groups that include: price variables, real variables, labor market variable, consumption variables,
monetary variables, interest rates and exchange rates, prices and nancial variables. In order to ex-
tract the base, we applied the Ng and MacCracker procedure (2016) and variables are stationarized
by the algorithm provided by these authors.
The prediction equation is based on (2). No lagged variable is used in the DI-DMA models,
only factors are used. However, in some comparison models there may be lagged variables. The
target variables were annualized so that all monthly observations could be used to forecast in other
horizons. For the real variables (IP, house starts and Unrate) the monthly annualization took place
as follows:
r
yt+h = (1200/h) ln(yt+h /ytr )

Where, yt+h
r
is the real variable in time t + h and yt+h which is the target variable in time
t + h. Let yt+h be the nominal variable in time t + h. For these nominal variables, such as IPI,
n

CPI and M2, the monthly annualization is given as follows:

13 Thedescription of variables, their transformations and their own database are available upon email request to
the authors.

10
 n
yt+h = (1200/h) ln(yt+h n
/ytn ) − 1200 ln(yt+1 /ytn )

Forecasts for four prediction horizons are performed: 1, 3 and 12 months. Estimated mo-
dels consider four combinations of forgetting parameters: {α, λ} = {(0.99, 0.99), (0.95, 0.95), (0.99, 0.95), (0.95,
Due to conciseness, results for all forgetting parameters for the DI-DMA extensions are not pre-
sented, only the best combination is reported. The criterion to select the best prediction is based
on the mean square prediction error (MSPE) for a given horizon and variable.
The DI-DMA models are compared to other prediction models for the same target varia-
bles. The alternative prediction models are: AR (4), Increased autoregressive factors such as those
of Stock and Watson (2002) (FAAR), Mallows Model Average (MMA), Jacknife Model Average
(JMA), Leave-h-out Model Average (LHO)14 and equal weight model average (SMA). To evaluate
forecasts, two statistics are introduced: i) root ratio of prediction square error related to the AR
model prediction (4) (REQMP) and ii) the absolute prediction error ratio related to the AR (4)
model prediction (RMAEP). Let ŷt+h,k be the prediction using the k model for horizon h., These
statistics are calculated through:
v
u PR
t P t=P +1 (ŷt+h,k
u − yt+h )2
RM SEFh,k = R 2
t=P +1 (ŷt+h,AR(4) − yt+h )

PR
|ŷt+h,k − yt+h |
RM AEFh,k = PR t=P +1
t=P +1 |ŷt+h,AR(4) − yt+h |

Table 4 and 5 introduces results for the prediction of the six macroeconomic variables
considered. In bold type, we have the models placed in columns that boast the best forecasts for
each variable. For example, for horizon h = 1 the value 0.8247 in the last column and in the line
corresponding to the CPI variable of Table 4 means that the DI-DMA-LAR model has a REQMP
of 18% lower than the AR (4).Still in this horizon (h = 1), predictions for the DI-DMA-CFPC
model for industrial production (IP) and for the unemployment rate (Unrate) have the least mean
square prediction error with respect to the AR (4). For the House Starts variable (Hous), the three
factor combinations, JMA, MMA and LHO were the most accurate. The performance dierence
among models dynamically combined through the DMA and the other models is bigger in monetary
variables. The DI-DMA-LAR model is the best forecaster for the CPI and PPI indexes and the
DI-DMA-CPFP model is better to predict the M2.
The DI-DMA model with (λ, α) = (0.99, 0.95) generates more ecient forecasts for real
variables when h = 3. The REQMP of this model compared to the AR (4) is 86%, 82% and 75%
lower for the IP, Hous AND Unrate, respectively. These percentages remain high when comparing
the REQMP of 0.1415 for the DI-DMA with (λ, α) = (0.99, 0.95)with those of the other models.
For example, the variance reaches 83% when compared to a REQMP of 0.8397 in the second best
14 For more details on the MMA, JMA and LHO, see Cheng and Hansen (2015).

11
 Tabela 4: RMSEF - DI-DMA Forecasts and their Extensions
DI-DMA DI-DMA DI-DMA DI-DMA DI-DMA DI-DMA DI-DMA
FAAR MMA JMA LHO SMA
(0.95,0.95) (0.99,0.99) (0.95,0.99) (0.99,0.95) LASSO LAR CFPC
Forecast horizon h = 1
IP 1.0101 1.0004 1.0004 1.0004 1.0004 1.0591 1.0102 1.0640 1.0050 1.0086 0.9915 0.9842
Hous 0.9899 0.9890 0.9890 0.9890 0.9890 1.0152 1.0194 1.0146 1.0147 1.0130 1.0154 1.0067
Unemp 0.9821 0.9753 0.9753 0.9753 0.9753 0.9625 0.9495 0.9495 0.9529 0.9461 0.9430 0.9402
M2 1.0093 1.0255 0.9777 0.9777 1.0267 0.8101 0.8066 0.8054 0.7986 0.7815 0.7811 0.7806
IPI 1.0373 0.9586 0.9545 0.9545 0.9626 0.9866 0.9616 0.9737 0.9476 0.9525 0.9342 0.9615
CPI 1.0336 0.9661 0.9529 0.9529 0.9676 0.8420 0.8469 0.8369 0.8461 0.8329 0.8247 0.8274
Forecast horizon h = 3
IP 1.0648 0.9392 0.9521 0.9521 0.9521 0.8441 0.8441 0.8762 0.1415 0.8397 0.8439 0.8163
Hous 1.0561 0.9469 0.9590 0.9590 0.9590 0.8935 0.8935 0.9246 0.1782 0.8820 0.8754 0.8650
Unemp 1.0157 0.9846 0.9613 0.9671 0.9613 0.9539 0.9539 0.9732 0.2526 0.9420 0.9276 0.9273

12
M2 0.9950 1.0050 0.9682 0.9973 0.9860 0.9828 0.9828 0.9929 0.9829 0.9647 0.9623 0.9650
IPI 1.0125 0.9876 0.9784 0.9931 0.9912 1.0180 1.0180 1.0151 1.0180 1.0025 0.9988 0.9951
CPI 1.0390 0.9625 0.9568 0.9689 0.9654 0.9660 0.9660 0.9669 0.9661 0.9671 0.9693 0.9844
Forecast horizon h = 12
IP 1.1653 0.8582 0.8572 0.9340 0.9047 0.7179 0.8849 0.8357 0.8387 0.7210 0.7809 0.8139
Hous 1.2076 0.8281 0.8540 0.9576 0.9320 0.6880 0.8681 0.7982 0.8120 0.7210 0.7538 0.8040
Unemp 1.1124 0.8990 0.9306 1.0342 1.0076 0.7586 0.9087 0.8539 0.8725 0.7529 0.7788 0.8089
M2 0.9575 1.0444 0.9892 1.0882 1.0696 0.9768 1.0545 0.9822 1.0363 0.9480 0.9868 0.9713
IPI 1.0183 0.9820 1.0043 1.0284 1.0236 0.9754 0.9933 0.9683 0.9857 0.9581 0.9674 0.9615
CPI 1.0383 0.9631 0.9624 0.9975 0.9855 0.9026 1.0065 0.9147 0.9936 0.9040 0.9255 0.9134
Notes: Table 4 introduces results for i) the root ratio of the square prediction error related to the AR (4) (REQMP) for the forecast horizons of one month, three months and twelve
months ahead. Six American macroeconomic variables are considered: Producer Price Index (PPI) and Consumer Price Index (CPI); Industrial Production Index (IP), , M2. house
starts (Hous) and unemployment rate (Unrate)). Results for the DMA applying factors use {α, λ} = {(0.99, 0.99), (0.95, 0.95), (0.99, 0.95), (0.95, 0.99)}.At the same time, in DMA
extensions with factors, only the results for the best model are presented considering the same variation of forgetting factors.
 Tabela 5: RMAEF - DI-DMA Forecasts and their Extensions
DI-DMA DI-DMA DI-DMA DI-DMA DI-DMA DI-DMA DI-DMA
FAAR MMA JMA LHO SMA
(0.95,0.95) (0.99,0.99) (0.95,0.99) (0.99,0.95) LASSO LAR CFPC
Forecast horizon h=1
IP 1.0088 0.9913 1.0082 1.0082 1.0082 1.0245 1.0213 1.0230 1.0217 1.0123 1.0026 0.9904

Hous 0.9699 1.0311 0.9888 0.9888 0.9888 1.0247 1.0240 1.0244 1.0219 1.0291 1.0215 1.0109
Unemp 0.9635 1.0379 0.9879 0.9879 0.9879 0.9549 0.9518 0.9438 0.9546 0.9486 0.9462 0.9413

M2 1.0113 0.9888 1.0027 1.0027 1.0027 0.7900 0.7928 0.7834 0.7851 0.7691 0.7673 0.7759

IPI 1.0285 0.9722 0.9511 0.9511 0.9511 0.9504 0.9481 0.9439 0.9360 0.9508 0.9312 0.9490
CPI 1.0432 0.9586 0.9528 0.9528 0.9528 0.8263 0.8467 0.8197 0.8445 0.8262 0.8139 0.8095
Forecast horizon h=3
IP 1.0257 0.9749 0.9519 0.9519 0.9519 0.8546 0.8546 0.8879 0.1484 0.8516 0.8590 0.8277
Hous 1.0407 0.9609 0.9625 0.9625 0.9625 0.9188 0.9188 0.9527 0.1891 0.8992 0.9059 0.8893
Unemp 1.0077 0.9923 0.9583 0.9670 0.9583 0.9654 0.9654 0.9899 0.2571 0.9475 0.9371 0.9353

13
M2 0.9996 1.0004 0.9664 1.0018 0.9906 0.9553 0.9553 0.9664 0.9553 0.9605 0.9635 0.9739
IPI 1.0019 0.9981 0.9765 0.9954 0.9911 0.9979 0.9979 1.0086 0.9979 0.9796 1.0027 0.9923
CPI 1.0512 0.9513 0.9510 0.9577 0.9523 0.9274) 0.9274 0.9346 0.9275 0.9352 0.9612 0.9696
Forecast horizon h = 12
IP 1.0426 0.9591 0.8790 1.0482 1.0052 0.7392 0.9019 0.8511 0.8482 0.7434 0.8050 0.8383
Hous 1.2616 0.7926 0.8085 0.9235 0.8772 0.6902 0.7972 0.8560 0.7934 0.6834 0.7648 0.8051
Unemp 1.1143 0.8974 0.9106 1.0236 1.0030 0.7503 0.8438 0.9080 0.8695 0.7371 0.7672 0.7909
M2 0.9484 1.0543 0.9940 1.1011 1.0806 0.9559 0.9629 1.0572 1.0456 0.9396 0.9725 0.9470
IPI 1.0080 0.9920 1.0036 1.0460 1.0345 0.9679 0.9636 0.9754 0.9744 0.9480 0.9626 0.9471
CPI 1.0463 0.9557 0.9519 1.0020 0.9848 0.8745 0.8832 0.9813 0.9675 0.8838 0.9001 0.8841
Notes: Table 4 introduces results for the absolute error prediction ratio related to the AR (4) (RMAEP) for the forecast horizons of one month, three months and twelve months ahead.
Six American macroeconomic variables are considered: Producer Price Index (PPI) and Consumer Price Index (CPI); Industrial Production Index (IP), , M2. house starts (Hous) and
unemployment rate (Unrate)). Results for the DMA applying factors use {α, λ} = {(0.99, 0.99), (0.95, 0.95), (0.99, 0.95), (0.95, 0.99)}.At the same time, in DMA extensions with factors,
only the results for the best model are presented considering the same variation of forgetting factors.
model to predict the IP, which is the DI-DMA-LASSO. Still in the same prediction horizon, the
DI-DMA-LAR is better to predict M2 and price indexes are better forecasted by the JMA model.
Finally, results for a 12-month horizon (h = 12), show that the best predictions are
obtained with the DI-DMA ((λ, α) = (0.95, 0.95))and the extension DI-DMA-LASSO. The rst
one generates better forecasts for the variables IP, Hous and CPI and the second one is better
for the other variables. For real variables, the REQMP of DI-DMA model types are on average,
28% lower than those of an AR (4). To summarize, models that use a dynamic factor weighting
including their extensions, boast more ecient predictions for most variables and for all horizons.
In fact, considering all variables and all horizons, DI-DMA models are the best forecasters in more
than 80% of cases.

5. Conclusion

This article proposes a new forecasting method that uses a dynamic combination of esti-
mated factors based on a large database. Such method, denominated DI-DMA, considers possible
parameter instabilities and uncertainties related to the correct prediction model specication. Be-
sides this, three DI-DMA extensions are suggested, in which variables are selected a priori to then
extract factors. Extensions include pre-selection using the LASSO and LAR methods and the
supervision of factors through the CFCP.
Applying Monte Carlo simulations, we veried that the DI-DMA models can generate bet-
ter forecasts when compared to dierent benchmarks, including the traditional factorial model in
dierent variability and uncertainty conditions in the functional form. In the empirical application,
we compare predictions for six macroeconomic variables in the USA: industrial production index,
M2, consumer and producer price indexes, unemployment rate and house starts. The DI-DMA
model has a pretty satisfactory performance in comparison to models that traditionally boast a
good forecasting performance by using estimated factors such as: equal weights models, model
weighed with the Mallows criterion and the augmented factorial model. In fact, in some cases, DI-
DMA extensions proved to have a much higher predictive eciency than the benchmarks, mainly
when the forecast horizon ranges from 3 to 12 months. DI-DMA models were superior to other
comparison models in more than 80% of cases.

6. References

14