Forecasting Dutch GDP and inflation using Alternative Factor Model Specifications based on Large and Small Datasets

We compare the factor forecasting performance of nested specifications of the generalized factor model based on various configurations of a large macroeconomic data set. The forecast simulation design involves in-sample model selection, factor estimation, parameter estimation and, finally, generating factor forecasts and factor augmented autoregressive forecasts. In order to empirically determine the importance of the size and the structure of the data set, we run the forecast simulation design for different configurations of the data set. We compare the factor model diagnostics of each specification and data configuration with the corresponding forecast performance. The results favour the factor structure as the specification that imposes the factor structure to the least extent and, hence, is allowed most flexibility to adapt to the data, is significantly being outperformed. Moreover, the results show that size matters as though smaller macroeconomic data sets exhibit stronger coherence, the factors being well fit do, however, generally not show improved forecasting performance. keywords: Factor Models, Macroeconomic Forecasting, Leading Indicators JEL-code: C43, C51, E32 Sveriges Riksbank, Monetary Policy Department, SE-103 37 Stockholm, Sweden, E-mail: [email protected]