Working Paper: CEPR ID: DP4981
Authors: Domenico Giannone; Lucrezia Reichlin; Luca Sala
Abstract: We analyse the panel of the Greenbook forecasts (sample 1970-96) and a large panel of monthly variables for the US (sample 1970-2003) and show that the bulk of dynamics of both the variables and their forecasts is explained by two shocks. Moreover, a two factor model which exploits, in real time, information on many time series to extract a two dimensional signal, produces a degree of forecasting accuracy of the federal funds rate similar to that of the markets, and, for output and inflation, similar to that of the Greenbook forecasts. This leads us to conclude that the stochastic dimension of the US economy is two. We also show that dimension two is generated by a real and nominal shock, with output mainly driven by the real shock and inflation by the nominal shock. The implication is that, by tracking any forecastable measure of real activity and price dynamics, the Central Bank can track all fundamental dynamics in the economy.
Keywords: forecasting; large datasets; monetary policy; real time analysis; Taylor rules
JEL Codes: C33; C53; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| real shock (Y70) | output (C67) |
| nominal shock (D80) | inflation (E31) |
| real shock (D80) | federal funds rate (E52) |
| nominal shock (D80) | federal funds rate (E52) |
| real shock (D80) | inflation (E31) |
| nominal shock (D80) | output (C67) |