Forecasting UK Industrial Production Over the Business Cycle

Abstract

This paper examines the information available through leading indicators for modelling and forecasting the UK quarterly index of production (seasonally adjusted). The emphasis is on one-quarter ahead prediction, especially over the 1990s recession. Linear specifications considered are univariate autoregressive models together with dynamic single indicator and multiple indicator models. Both univariate and leading indicator versions of nonlinear Markov switching specifications are also examined. In the latter case, the transition probabilities are modelled as logistic functions of the leading indicators, allowing the lead times to differ for the expansion to expansion and recession to recession probabilities. Despite general evidence that the term structure of interest rates helps regime classification in the Markov switching models, these models perform relatively poorly in forecasting the 1990s production recession. It is suggested that this poor performance may be due to the nature of that recession, which differed from previous major UK postwar recessions in having no single quarter where industrial production declined substantially. However, a three indicator linear specification does well. The leading indicator variables in this latter model are a short-term interest rate, the stock market dividend yield and the optimism balance from the quarterly survey conducted by the Confederation of British Industry.