Forecasting with an economic model and the role of adjustments
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Forecasting with an Economic Model and the Role of Adjustments. Andrew P. Blake CCBS/HKMA May 2004. What is a forecast?. An assessment of the unknown Usually of variables only known in the future Often probabilistic Forecast could be just a series of numbers

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Forecasting with an economic model and the role of adjustments

Forecasting with an Economic Model and the Role of Adjustments

Andrew P. Blake

CCBS/HKMA May 2004


Forecasting with an economic model and the role of adjustments

What is a forecast?

  • An assessment of the unknown

    • Usually of variables only known in the future

    • Often probabilistic

  • Forecast could be just a series of numbers

  • Could be a forecast of the distribution of possible outcomes

  • Forecasters therefore produce point, interval and density forecasts

    • Bank of England fan chart is a density forecast


What are adjustments

What are adjustments?

  • Adjustments are needed because we use judgement

  • This may be imposed using information from outside the model

    • It may reflect model inadequacy

    • It may reflect data inadequacy

    • It may reflect expert opinion


Forecasting with an economic model and the role of adjustments

Forecasting framework

  • How could we make forecasts?

    • ‘Make them up’

      • Assess (a subset of) available data and judgement to produce forecast

    • Use a (statistical) model

  • Forecast horizons

    • ‘Nowcasting’: forecasting current or past but unknown data

    • Otherwise one minute to a hundred years

      • Hundred year horizon unlikely to be very accurate


Forecasting with an economic model and the role of adjustments

Modeling framework

  • What kinds of models are relevant?

    • Statistical and econometric

    • Univariate and multivariate

    • Structural and reduced form

  • Tools

    • Spreadsheets

    • Eviews, TSP, PcGive

    • Gauss, Matlab, Ox

    • WinSolve, Troll, Dynare


Forecasting with an economic model and the role of adjustments

The process of forecasting

  • Where do you start?

    • Previous forecast:

      • Existing data, existing model

      • New data, new model?

    • ‘From scratch’

  • What has changed since the last time?

    • Impact of ‘news’

      • Sources of shocks


Forecasting with an economic model and the role of adjustments

The process of forecasting (cont.)

  • How do we incorporate news?

    • Updates to historical data

    • Previously unavailable data

    • Revisions to the model

      • Previous failures may need correcting

    • ‘Adjustments’ to the forecast

      • From non-model data

      • Judgement


Forecasting with an economic model and the role of adjustments

Simple forecasting

  • Univariate models

    • ARIMA modeling

    • Exponential smoothing (more weight on recent observations)

  • Clements and Hendry suggest that

    fits economic data well. For forecasting use:


Forecasting with an economic model and the role of adjustments

Simple forecasting (cont.)

  • Simple multivariate models

    • VAR widely used

    • Easy to re-estimate/update

    • Models have straightforward interpretation

  • Minimum intervention needed

    • Properties depend on few choice variables

    • Benchmark forecast


Var forecast

VAR forecast

Data

Residuals

Forecast

Interest rate

Inflation rate


What do the residuals tell us

What do the residuals tell us?

  • Tell us about the goodness-of-fit of the model

  • Very useful over the recent past which may not be used in model estimation

    • May be going ‘off-track’

  • Use in determining adjustments for a forecast


Forecasting with an economic model and the role of adjustments

More sophisticated forecasting

  • Structural Economic Model (SEM)

    • Multiple equations (2 to 5000)

    • Estimated/calibrated/imposed coefficients

    • Rich dynamics

    • Expectations

    • Complex accounting structures

  • Complicated to use

    • Institutional and technical considerations


A quarterly forecast round

A ‘quarterly’ forecast round

Revise assumptions

Existing model, existing data, old forecast

Final forecast

National accounts, other data release

Other data releases (prices, exchange rates)

Run forecast on new data

‘Tuning’

Assumptions:exogenous, residuals, define ragged edge

Examine residuals, re-estimate model, revise assumptions

Forecast evaluation

‘Issues’ meetings

Scenario analysis, risk assessment

Create database


Forecasting with an economic model and the role of adjustments

‘Week 0’


Forecasting with an economic model and the role of adjustments

New data, same old problems

  • ‘Issues’ meetings

    • Where have previous forecast failed?

    • Where has the forecast model failed?

  • New data

    • Start of forecast often determined by release dates, e.g. National Accounts

    • Create model database (transforms etc)

    • Make ‘first quarter’ assumptions

      • Expert analysis

      • Partial information


Forecasting with an economic model and the role of adjustments

The ‘ragged edge’

Forecast date

Time

New/revised data

Assumptions

Old data


Forecasting with an economic model and the role of adjustments

Dealing with the ragged edge

  • Exogenise all past true data values

    • Incorporate historical add factors

  • Exogenise ‘first quarter’ assumed data

  • Exogenise future assumptions

  • Solve the model from far enough back


Forecasting with an economic model and the role of adjustments

News: data revisions

  • The past isn’t always what it used to be

    • ‘Real time’ data sets show significant changes

      • Eggington, Pick & Vahey, 2002

      • Castle & Ellis, 2002, Band of England QB

  • Question of what you wish to forecast

    • Do you wish to forecast the first outturn or final estimate?

    • Markets may react less strongly to revised data than ‘new’ data


Forecasting with an economic model and the role of adjustments

Data revisions


Forecasting with an economic model and the role of adjustments

‘Week 1’


Forecasting with an economic model and the role of adjustments

Old model, same old problems

  • Exogenous variable assumptions

    • All things exogenous to the model

    • Rest of the world, policy variables, fiscal authorities

  • ‘Residuals’

    • Adjustments or add-factors

    • Constant values, future profiles

    • Helps robustify to structural breaks (Clements and Hendry)

      • ECMs helpful in this respect


Adjustments

Adjustments

  • What does the model tell us about how our forecast may be failing?

  • Need to look at the implicit residuals

  • We need to ensure that any adjustments are consistent with the model – or have a good reason why not


Residual profiles

Residual profiles

Ideal

Possible break

Over-prediction


Forecasting with an economic model and the role of adjustments

Evaluating the model forecast

  • Check performance of individual equations

    • Implicit residuals a guide to how well equations track the recent past

    • Forecast residuals may be averages of last one or two years, may fade back

  • Alternate/revised equations

    • Models may have alternate equations, perhaps on a trial basis

    • Equations may need to be re-estimated if data sufficiently revised or latest data inconsistent


Forecasting with an economic model and the role of adjustments

Evaluating the forecast (cont.)

  • Check assumptions

    • Are the exogenous variables consistent with the forecast?

      • i.e. are productivity trends consistent with growth

  • Does the forecaster like the forecast?

  • Does the MPC like the forecast?

    • Question of ownership

  • Iterate


Forecasting with an economic model and the role of adjustments

‘Week 2’


Forecasting with an economic model and the role of adjustments

More news

  • For any lengthy forecast process will usually need to incorporate additional data

    • More data on exogenous variables may be available

      • Perhaps the world forecast updated

    • Perhaps non-National Accounts data becomes available

      • Price, wage and production indices

      • Monthly data

    • Financial market data needs updating


Forecasting with an economic model and the role of adjustments

More news (cont.)

  • Impacts on:

    • Exogenous variables

    • Adjustment/residual settings

    • Equation fit

  • Do everything you did in Week 1 (again)

  • Iterate

    • Incorporate new data

    • New or different judgments


Forecasting with an economic model and the role of adjustments

‘Week n’


Forecasting with an economic model and the role of adjustments

Finalise forecast

  • Agree on final numbers

  • Assess impact of news

  • Decide main risks to the forecast

    • Part of the whole forecast process: the forecaster learns what drives the forecast

    • Scenario analysis

    • Perhaps present results using formal density forecast or provide standard errors


A quarterly forecast round1

A ‘quarterly’ forecast round

Revise assumptions

Existing model, existing data, old forecast

Final forecast

National accounts, other data release

Other data releases (prices, exchange rates)

Run forecast on new data

‘Tuning’

Assumptions:exogenous, residuals, define ragged edge

Examine residuals, re-estimate model, revise assumptions

Forecast evaluation

‘Issues’ meetings

Scenario analysis, risk assessment

Create database


Forecasting with an economic model and the role of adjustments

Forecasting with rational expectations

  • Models such as the new BEQM

  • Expectations may be structurally important

    • Exchange rates

    • Consumption Euler equations, etc.

  • Forecast values affect current behaviour

    • Any updates to path of exogenous variables become news and affect ‘jump variables’

    • No news no jumps


Forecasting with an economic model and the role of adjustments

Forecasting with rational expectations (cont.)

  • How does the forecasting process change?

    • Variables ‘jump about’ more

    • Seemingly trivial changes have big effects

    • Residual adjustments need to be made much more carefully

      • Future residuals affect current behaviour

    • Up-to-the-minute data may incorporate the news already

      • Jumps adjusted to where you are now


Forecasting with an economic model and the role of adjustments

Forecasting with leading indicators

  • Nothing essentially different

    • Indicator variables often available at different frequency to main forecast

    • Used as alternative ‘satellite’ models

  • Dynamic factor modeling

    (unobserved components)

    • Stock and Watson (2002)

    • Camba-Medez et al. (2001)


Forecasting with an economic model and the role of adjustments

Forecast post mortem

  • Part of the process is to see what went wrong

    • Informal judgement when the model is deficient

    • Tests of forecast accuracy

      • Diebold and Mariano (1995)

  • Does the forecaster add value?


Forecasting with an economic model and the role of adjustments

  • Camba-Mendez, G. et al. (2001) ‘An Automatic Leading Indicator of Economic Activity: Forecasting GDP Growth for European Countries’, Econometrics Journal 4(1), S56-90.

  • Clements, M.P and D. Hendry (1995) ‘Macro-economic Forecasting and Modelling’, Economic Journal 105(431), 1001-1013.

  • Diebold, F.X and R. Mariano (1995) ‘Comparing Predictive Accuracy’, Journal of Business and Economic Statistics 13(3), 253-63

  • Egginton, D., A. Pick and S.P. Vahey (2002) ‘‘Keep It Real!’: A Real-Time UK Macro Data Set’, Economics Letters 77(1), 15-22.

  • Stock, J.H and M. Watson (2002) ‘Macroeconomic Forecasting Using Diffusion Indexes’, Journal of Business and Economic Statistics 20(2), 147-162


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