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Spurious Principal Components

Philip Hans Franses and Eva Janssens

No EI2017-31, Econometric Institute Research Papers from Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute

Abstract: The Principal Component Regression is often used to forecast macroeconomic variables when there are many predictors. In this letter, we argue that it makes sense to pre-whiten the predictors before including these in a PCR. With simulation experiments, we show that without such pre-whitening, spurious principal components can appear, and that these can become spuriously significant in a PCR. With an illustration to annual inflation rates for five African countries, we show that non-spurious principal components can be genuinely relevant in empirical forecasting models.

Keywords: Principal Component Regression; Pre-whitening; Spurious Regressions (search for similar items in EconPapers)
JEL-codes: C52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm and nep-ets
Date: 2017-11-01
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Journal Article: Spurious principal components (2019) Downloads
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