Forecasting with Leading Indicators by means of the Principal Covariate Index

Abstract

A new method of leading index construction is proposed, which explicitly takes into account the purpose of using the index for forecasting a coincident economic indicator. This so-called principal covariate index combines the need for compressing the information in a large number of individual leading indicator variables with the objective of forecasting. In an empirical application to forecast future growth rates of the Conference Board’s Composite Coincident Index and its constituents, the forecasts of the principal covariate index are more accurate than those obtained either from the Composite Leading Index of the Conference Board or from an alternative index-based on principal components. JEL Classification: C32, C53, E27 Keywords: index construction, business cycles, principal component, principal covariate, time series forecasting, variable selection