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Forecasting Using Targeted Diffusion Indexes

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Executive Summary

The simplicity of the standard diffusion index model of Stock and Watson has certainly contributed to its success among practitioners resulting in a growing body of literature on factor-augmented forecasts. However, as pointed out by Bai and Ng, the ranked factors considered in the forecasting equation depend neither on the variable to be forecasted nor on the forecasting horizon. The author proposes a refinement of the standard approach that retains the computational simplicity while coping with this limitation.

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