The Implications for Econometric Modelling of Forecast Failure

Abstract

To reconcile forecast failure with building congruent empirical models, we analyze the sources of mis‐prediction. This reveals that ex ante forecast failure is purely a function of forecast‐period events, not determinable from in‐sample information. The primary causes are unmodelled shifts in deterministic factors, rather than model mis‐specification, collinearity, or a lack of parsimony. We examine the effects of deterministic breaks on equilibrium‐correction mechanisms, and consider the role of causal variables. Throughout, Monte Carlo simulation and empirical models illustrate the analysis, and support a progressive research strategy based on learning from past failures.