Journal of Forecasting / A multicountry dynamic factor model with stochastic volatility for euro area business cycle analysis

This paper develops a dynamic factor model that uses euro area countryspecific information on output and inflation to estimate an areawide measure of the output gap. Our model assumes that output and inflation can be decomposed into countryspecific stochastic trends and a common cyclical component. Comovement in the trends is introduced by imposing a factor structure on the shocks to the latent states. We moreover introduce flexible stochastic volatility specifications to control for heteroscedasticity in the measurement errors and innovations to the latent states. Carefully specified shrinkage priors allow for pushing the model towards a homoscedastic specification, if supported by the data. Our measure of the output gap closely tracks other commonly adopted measures, with small differences in magnitudes and timing. To assess whether the modelbased output gap helps in forecasting inflation, we perform an outofsample forecasting exercise. The findings indicate that our approach yields superior inflation forecasts, both in terms of point and density predictions. (VLID)5361958