Predicting Ordinary and Severe Recessions with a Three-State Markov-Switching Dynamic Factor Model. An Application to the German Business Cycle

We use a Markow-switching dynamic factor model with three states for Germany with indicators selected by the Elastic Net. The states represent expansions, normal - and severe recessions. Adding a third state helps to identify all business cycle turning points in-sample and in real-time. Combining the factor and the recession probabilities with a GDP forecasting model yields accurate nowcasts and a correct prediction of the timing of the Great Recession and its recovery one quarter in advance.