We conduct a detailed simulation study of the forecasting performance of diffusion index-based methods in short samples with structural change. We consider several data generation processes, to mimic different types of structural change, and compare the relative forecasting performance of factor models and more traditional time series methods. We find that changes in the loading structure of the factors into the variables of interest are extremely important in determining the performance of factor models. We complement the analysis with an empirical evaluation of forecasts for the key macroeconomic variables of the Euro area and Slovenia, for which relatively short samples are officially available and structural changes are likely. The results are coherent with the findings of the simulation exercise and confirm the relatively good performance of factor-based forecasts in short samples with structural change.
Banerjee, A., Marcellino, M. and Masten, I. (2008), "Chapter 4 Forecasting Macroeconomic Variables Using Diffusion Indexes in Short Samples with Structural Change", Rapach, D.E. and Wohar, M.E. (Ed.) Forecasting in the Presence of Structural Breaks and Model Uncertainty (Frontiers of Economics and Globalization, Vol. 3), Emerald Group Publishing Limited, Bingley, pp. 149-194. https://doi.org/10.1016/S1574-8715(07)00204-7
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