Fundamentals versus the leading index-the forecasting of Canada's output growth since 1991: an encompassing approach

We evaluate the ability of Statistics Canada's Composite Leading Index to forecast Canada's real Gross Domestic Product (GDP) growth rate in the backdrop of the Duguay (1994, JME) model and also the dynamic and the error-correction variants of the Duguay model, that already include the 'fundamentals' of the Canadian business cycle. The results show that integrating the index in these models substantially improve the in-sample fit of the models and also provide an explanation for the 'perplexingly' large influence of the US real GDP on aggregate spending in the Canadian economy. Out-of-sample forecasts over the inflation-targeting regime (January 1991-April 2004), evaluated using the forecast encompassing tests, confirm that the index contains an important amount of new information about the future growth rate, quite apart from the information contained in the fundamentals.