The principal component regression (PCR) is often used to forecast macroeconomic variables when there are many predictors. In this letter, we argue that it makes sense to pre-whiten the predictors before including these in a PCR. With simulation experiments, we show that without such pre-whitening, spurious principal components can appear and that these can become spuriously significant in a PCR. With an illustration to annual inflation rates for five African countries, we show that non-spurious principal components can be genuinely relevant in empirical forecasting models.

, ,,
Econometric Institute Reprint Series
Applied Economics Letters
Department of Econometrics

Franses, P. H., & Janssens, E. (2018). Spurious principal components. Applied Economics Letters, 26(1), 37–39. doi:10.1080/13504851.2018.1433292