The Role of Financial Variables in Predicting Economic Activity

50 Pages Posted: 25 Nov 2009

See all articles by Raphael A. Espinoza

Raphael A. Espinoza

International Monetary Fund (IMF)

Fabio Fornari

European Central Bank (ECB)

Marco J. Lombardi

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: November 24, 2009

Abstract

Previous research has shown that the US business cycle leads the European cycle by a few quarters, and can therefore help predicting euro area GDP. We investigate whether financial variables provide additional predictive power. We use a VAR model of the US and the euro area GDPs and extend it to take into account common global shocks and information provided by selected combinations of financial variables. In- sample analysis shows that shocks to financial variables influence real activity with a peak around 4 to 6 quarters after the shock. Out-of-sample Root-Mean- Squared Forecast Error (RMFE) shows that adding financial variables yields smaller errors in forecasting US economic activity, especially at a five-quarter horizon, but the gain is overall tiny in economic terms. This link is even less prominent in the euro area, where financial indicators do not improve short and medium term GDP forecasts even when their timely availability, relative to a given GDP release, is exploited. The same conclusion is reached with a dataset of quarterly industrial production indices, although financial variables marginally improve forecasts of monthly industrial production. We argue that the findings that financial variables have no predictive power for future activity in the euro area relate to the unconditional nature of the RMFE metric. When forecasting ability is assessed as if in real time (i.e. conditionally on the information available at the time when forecasts are made), we find that models using financial variables would have been preferred in many episodes, and in particular between 1999 and 2002. Results from the historical decomposition of a VAR model indeed suggest that in that period shocks were predominantly of financial nature.

Keywords: VAR, Financial Variables, International Linkages, Conditional Forecast

JEL Classification: F30, F42, F47

Suggested Citation

Espinoza, Raphael A. and Fornari, Fabio and Lombardi, Marco Jacopo, The Role of Financial Variables in Predicting Economic Activity (November 24, 2009). ECB Working Paper No. 1108, Available at SSRN: https://ssrn.com/abstract=1498989

Raphael A. Espinoza

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://oxford.academia.edu/RaphaelEspinoza

Fabio Fornari

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Marco Jacopo Lombardi (Contact Author)

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland
+41612809492 (Phone)

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