Lecture Notes in Macroeconomic and Financial

Forecasting (BSc course at UNISG)
Paul S¨oderlind
26 January 2006

1University of St. Gallen. Address: s/bf-HSG, Rosenbergstrasse 52, CH-9000 St. Gallen,
Switzerland. E-mail: Paul.Soderlind@unisg.ch. I thank Michael Fischer for comments and help.
Document name: MFForecastAll.TeX.

Contents

1 Elementary Statistics 4
1.1 Mean, Standard Deviation, Covariance and Correlation . . . . . . . . 4
1.2 Least Squares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 Presenting Economic Data . . . . . . . . . . . . . . . . . . . . . . . 13
2 Trends and Seasons 16
2.1 Trends, Cycles, Seasons, and the Rest . . . . . . . . . . . . . . . . . 17
2.2 Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.3 Seasonality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3 Forecasting 24
3.1 Evaluating Forecast Performance . . . . . . . . . . . . . . . . . . . . 24
3.2 Combining Forecasts from Different Forecasters/Models . . . . . . . 28
3.3 Forecast Uncertainty and Disagreement . . . . . . . . . . . . . . . . 28
3.4 Words of Wisdom: Forecasting in Practice . . . . . . . . . . . . . . . 29
4 Time Series Analysis 30
4.1 Autocorrelations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.2 AR(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.3 AR(p) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.4 ARMA(p,q) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
4.5 VAR(p) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5 Overview of Macroeconomic Forecasting 39
5.1 The Forecasting Process . . . . . . . . . . . . . . . . . . . . . . . . 39
5.2 Forecasting Institutes . . . . . . . . . . . . . . . . . . . . . . . . . . 41
6 Business Cycle Facts 42
6.1 Key Features of Business Cycle Movements . . . . . . . . . . . . . . 42
6.2 Defining “Recessions” . . . . . . . . . . . . . . . . . . . . . . . . . 46
7 Data Quality, Survey Data and Indicators 48
7.1 Poor and Slow Data: Data Revisions . . . . . . . . . . . . . . . . . . 48
7.2 Survey Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
7.3 Leading and Lagging Indicators . . . . . . . . . . . . . . . . . . . . 54
8 Using Financial Data in Macroeconomic Forecasting 56
8.1 Financial Data as Leading Indicators of the Business Cycle . . . . . . 56
8.2 Nominal Interest Rates as Forecasters of Future Inflation . . . . . . . 57
8.3 Forward Prices as Forecasters of Future Spot Prices . . . . . . . . . . 59
8.4 Long Interest Rates as Forecasters of Future Short Interest Rates . . . 60
9 Macroeconomic Models 62
9.1 A Traditional Large Scale Macroeconometric Model . . . . . . . . . 62
9.2 A Modern Aggregate Macro Model . . . . . . . . . . . . . . . . . . 65
9.3 Forecasting Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . 67
9.4 Forecasting Monetary Policy . . . . . . . . . . . . . . . . . . . . . . 68
9.5 VAR Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
A Details on the Financial Parity Conditions 69
A.1 Expectations Hypothesis and Forward Prices . . . . . . . . . . . . . . 69
A.2 Covered and Uncovered Interest Rate Parity . . . . . . . . . . . . . . 70
A.3 Bonds, Zero Coupon Interest Rates . . . . . . . . . . . . . . . . . . . 71
10 Stock (Equity) Prices 76
10.1 Returns and the Efficient Market Hypothesis . . . . . . . . . . . . . . 76
10.2 Time Series Models of Stock Returns . . . . . . . . . . . . . . . . . 77
10.3 Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
10.4 Fundamental Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 83
10.5 Security Analysts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
10.6 Expectations Hypothesis and Forward Prices . . . . . . . . . . . . . . 91
11 Exchange Rates 92
11.1 What Drives Exchange Rates? . . . . . . . . . . . . . . . . . . . . . 92
11.2 Forecasting Exchange Rates . . . . . . . . . . . . . . . . . . . . . . 94
12 Interest Rates 96
12.1 Interest Rate Analysts . . . . . . . . . . . . . . . . . . . . . . . . . . 96
13 Options 98
13.1 Risk Neutral Pricing of a European Call Option . . . . . . . . . . . . 98
13.2 Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
13.3 Implied Volatility: A Measure of Market Uncertainty . . . . . . . . . 99
13.4 Subjective Distribution: The Shape of Market Beliefs . . . . . . . . . 100