Forecasting economic time series using targeted predictors

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 in the 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 often leads 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 have systematic 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 practice of factor forecasting is unnecessarily restrictive. (c) 2008 Elsevier B.V. All rights reserved.