The role of financial variables in predicting economic activity

Raphael Espinoza (), Fabio Fornari () and Marco Lombardi

No 1108, Working Paper Series from European Central Bank

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 fore-casting 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 fore- casts 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. JEL Classification: F30, F42, F47

Keywords: conditional forecast; financial variables; international linkages; VAR (search for similar items in EconPapers)
Date: 2009-11
New Economics Papers: this item is included in nep-cba, nep-cfn, nep-eec and nep-for
Note: 495651
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Citations: View citations in EconPapers (16)

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Journal Article: The Role of Financial Variables in predicting economic activity (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20091108

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