Forecasting US recessions: The role of sentiment

The Role of Credit in Predicting US Recessions

“…Our main interest is in a set of credit variables discussed in more detail below, but we also employ a set of classic recession predictors as well as common factors based on a large panel of financial and macroeconomic variables. The extraction of the common factors follows a standard procedure used in the previous literature (see, for example, Stock and Watson , Christiansen et al, ). Let Z t be a T × N panel of macroeconomic and financial variables with individual elements z i t .…”

“…Although ξ = 0.5 is a natural threshold in equation (), it is not a fully objective selection, because the success ratios and market timing tests are highly dependent on the selected threshold. Therefore, we also look at an alternative approach to assess the accuracy of probability forecasts, namely the receiver operating characteristic (ROC) curve, which has recently been used in a growing number of economic applications (see, for example, Berge and Jorda , Schularick and Taylor , Lahiri and Wang , Christiansen et al, ). The ROC curve is a mapping of the true positive rate: and the false positive rate: for all possible thresholds 0≤ ξ ≤1, described as an increasing function in [0,1] × [0,1] space, with TP( ξ ) plotted on the y ‐axis and FP|( ξ ) on the x ‐axis.…”

“…We test the null hypothesis of AUC = 0.5, implying no predictability using standard techniques (see Hanley and McNeil ), applied recently by Berge and Jorda () and Christiansen et al. (), among others, in economic applications.…”

“…We use the Federal Funds rate (FFR) as the short interest rate, following Estrella and Hardouvelis (), Wright () and Christiansen et al. (). Finally, based on the promising findings of Christiansen et al.…”

“…Methodologically, we follow the footsteps of Christiansen et al. (), who study the role of sentiment variables in predicting US recessions using factor‐augmented probit models (see also Chen et al ., , Bellégo and Ferrara ). This approach is particularly compelling, because it allows us to control for the effects of classical recession predictors and common factors based on a large panel of financial and macroeconomic variables, thus providing more robust results than traditional methods.…”