Determining Number of Factors in Dynamic Factor Models Contributing to GDP Nowcasting

Real-time nowcasting is a process to assess current-quarter GDP from timely released economic and financial series before the figure is disseminated in order to catch the overall macroeconomic conditions in real time. In economic data nowcasting, dynamic factor models (DFMs) are widely used due to their abilities to bridge information with different frequencies and to achieve dimension reduction. However, most of the research using DFMs assumes a fixed known number of factors contributing to GDP nowcasting. In this paper, we propose a Bayesian approach with the horseshoe shrinkage prior to determine the number of factors that have nowcasting power in GDP and to accurately estimate model parameters and latent factors simultaneously. The horseshoe prior is a powerful shrinkage prior in that it can shrink unimportant signals to 0 while keeping important ones remaining large and practically unshrunk. The validity of the method is demonstrated through simulation studies and an empirical study of nowcasting U.S. quarterly GDP growth rates using monthly data series in the U.S. market.