Spurious Principal Components
Philip Hans Franses and
No EI2017-31, Econometric Institute Research Papers from Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute
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)
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Journal Article: Spurious principal components (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:ems:eureir:102704
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