How good are dynamic factor models at forecasting output and inflation? A meta-analytic approach

This paper surveys existing factor forecast applications for real economic activity and inflation by means of a meta-analysis and contributes to the current debate on the determinants of the forecast performance of large-scale dynamic factor models relative to other models. We find that, on average, factor forecasts are slightly better than other models' forecasts. In particular, factor models tend to outperform small-scale models, whereas they perform slightly worse than alternative methods which are also able to exploit large datasets. Our results further suggest that factor forecasts are better for US than for UK macroeconomic variables, and that they are better for US than for euro-area output; however, there are no significant differences between the relative factor forecast performance for US and euro-area inflation. There is also some evidence that factor models are better suited to predict output at shorter forecast horizons than at longer horizons. These findings all relate to the forecasting environment (which cannot be influenced by the forecasters). Among the variables capturing the forecasting design (which can, by contrast, be influenced by the forecasters), the size of the dataset from which factors are extracted seems to positively affect the relative factor forecast performance. There is some evidence that quarterly data lend themselves better to factor forecasts than monthly data. Rolling forecasts are preferable to recursive forecasts. The factor estimation technique seems to matter as well. Other potential determinants - namely whether forecasters rely on a balanced or an unbalanced panel, whether restrictions implied by the factor structure are imposed in the forecasting equation or not and whether an iterated or a direct multi-step forecast is made - are found to be rather irrelevant. Moreover, we find no evidence that pre-selecting the variables to be included in the panel from which factors are extracted helped to improve factor forecasts in the past.