DP14472 Forecasting in the Presence of Instabilities: How Do We Know Whether Models Predict Well and How to Improve Them

Author(s): Barbara Rossi
Publication Date: March 2020
Keyword(s): business cycles, Density forecasts, Forecast Confidence Intervals, Forecasting, great recession, inflation, Instabilities, output growth, Structural Breaks, Time variation
JEL(s): D1, E21, E4, E52, H31, I3
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14472

This article provides guidance on how to evaluate and improve the forecasting ability of models in the presence of instabilities, which are widespread in economic time series. Empirically relevant examples include predicting the financial crisis of 2007-2008, as well as, more broadly, fluctuations in asset prices, exchange rates, output growth and inflation. In the context of unstable environments, I discuss how to assess models' forecasting ability; how to robustify models' estimation; and how to correctly report measures of forecast uncertainty. Importantly, and perhaps surprisingly, breaks in models' parameters are neither necessary nor sufficient to generate time variation in models' forecasting performance: thus, one should not test for breaks in models' parameters, but rather evaluate their forecasting ability in a robust way. In addition, local measures of models' forecasting performance are more appropriate than traditional, average measures.