Evaluating forecasts from factor models for Canadian GDP growth and core inflation

This paper evaluates the performance of static and dynamic factor models for forecasting Canadian real output growth and core inflation on a quarterly basis. We extract the common component from a large number of macroeconomic indicators, and use the estimates to compute out-of-sample forecasts under a recursive and a rolling scheme with different window sizes. Forecasts from factor models are compared with those from AR(p) models as well as IS- and Phillips-curve models. We find that factor models can improve the forecast accuracy relative to standard benchmark models, for horizons of up to 8 quarters. Forecasts from our proposed factor models are also less prone to committing large errors, in particular when the horizon increases. We further show that the choice of the sampling-scheme has a large influence on the overall forecast accuracy, with smallest rolling-window samples generating superior results to larger samples, implying that using limited-memory” estimators contribute to improve the quality of the forecasts.