Forgetting approaches to improve forecasting

Research output: Contribution to journalArticlepeer-review

Abstract

There is widespread evidence of parameter instability in the literature. One way to account for this feature is through the use of time-varying parameter (TVP) models that discount older data in favor of more recent data. This practice is often known as forgetting and can be applied in several different ways. This paper introduces and examines the performance of different (flexible) forgetting methodologies in the context of the Kalman filter. We review and develop the theoretical background and investigate the performance of each methodology in simulations as well as in two empirical forecast exercises using dynamic model averaging (DMA). Specifically, out-of-sample DMA forecasts of Consumer Price Index (CPI) inflation and S&P500 returns obtained using different forgetting approaches are compared. Results show that basing the amount of forgetting on the forecast error does not perform as well as avoiding instability by placing bounds on the parameter covariance matrix.

Original languageEnglish
Pages (from-to)1356-1371
JournalJournal Of Forecasting
Volume41
Issue number7
DOIs
Publication statusPublished - Nov 2022

Keywords

  • dynamic model averaging
  • forgetting
  • inflation
  • Kalman filter
  • stock returns

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