Forecasting regional house price inflation: a comparison between dynamic factor models and vector autoregressive models

This paper uses the dynamic factor model framework, which accommodates a large cross-section of macroeconomic time series, for forecasting regional house price inflation. In this study, we forecast house price inflation for five metropolitan areas of South Africa using principal components obtained from 282 quarterly macroeconomic time series in the period 1980:1 to 2006:4. The results, based on the root mean square errors of one to four quarters ahead out‐of‐sample forecasts over the period 2001:1 to 2006:4 indicate that, in the majority of the cases, the Dynamic Factor Model statistically outperforms the vector autoregressive models, using both the classical and the Bayesian treatments. We also consider spatial and non‐spatial specifications. Our results indicate that macroeconomic fundamentals in forecasting house price inflation are important. Copyright (C) 2010 John Wiley & Sons, Ltd.