Spurious principal components |
| |
Authors: | Philip Hans Franses Eva Janssens |
| |
Institution: | Econometric Institute, Erasmus School of Economics, Rotterdam, The Netherlands |
| |
Abstract: | The principal component regression (PCR) is often used to forecast macroeconomic variables when there are many predictors. In this letter, we argue that it makes sense to pre-whiten the predictors before including these in a PCR. With simulation experiments, we show that without such pre-whitening, spurious principal components can appear and that these can become spuriously significant in a PCR. With an illustration to annual inflation rates for five African countries, we show that non-spurious principal components can be genuinely relevant in empirical forecasting models. |
| |
Keywords: | Principal component regression pre-whitening spurious regressions |
|
|