Forecasting Canadian Reccessions Using Qual VAR Model

Abstract

This paper applies the Qual VAR method developed recently by Dueker (2005) to search for the ideal macroeconomic indicator(s) that fully fit the in-sample movements of business cycle fluctuations and accurately predict the out-of-sample recession probability in Canada. Compared to previous works, I apply a more comprehensive dynamic forecasting model on the most updated Canadian macroeconomic dataset. The results are threefold: First, consistent with the findings by Estrella and Mishkin (1998), the term spread between 10-year and 3-month marketable bonds on its own provides a reliable in-sample goodness of fit. Introducing additional leading financial variables, such as the bank rate and major stock market indices, does not entirely distort the forecasting performance of the term spread. Second, coupling the term spread with the US-Canada noon-spotted exchange rate gives us the best short-term out-of-sample forecasting power. Third, the combination of the term spread, exchange rate, and the growth rate of real GDP provides convincing recession prediction in longer horizons.