Algorithmic Modelling of Financial Conditions for Macro Predictive Purposes: Pilot Application to USA Data

Abstract

Aggregate financial conditions indices (FCIs) are constructed to fulfil two aims: (i) The FCIs should resemble non-model-based composite indices in that their composition is adequately invariant for concatenation during regular updates; (ii) the concatenated FCIs should outperform financial variables conventionally used as leading indicators in macro models. Both aims are shown to be attainable once an algorithmic modelling route is adopted to combine leading indicator modelling with the principles of partial least-squares (PLS) modelling, supervised dimensionality reduction, and backward dynamic selection. Pilot results using US data confirm the traditional wisdom that financial imbalances are more likely to induce macro impacts than routine market volatilities. They also shed light on why the popular route of principal-component based factor analysis is ill-suited for the two aims.