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How is Machine Learning Useful for Macroeconomic Forecasting?

We move beyond Is Machine Learning Useful for Macroeconomic Forecasting? by adding the how. The current forecasting literature has focused on matching specific variables and horizons with a particularly successful algorithm. To the contrary, we study a wide range of horizons and variables and learn about the usefulness of the underlying features driving ML gains over standard macroeconometric methods. We distinguish 4 so-called features (nonlinearities, regularization, cross-validation and alternative loss function) and study their behavior in both the data-rich and data-poor environments. To do so, we carefully design a series of experiments that easily allow to identify the “treatment” effects of interest. We conclude that (i) more data and nonlinearities are true game-changers for macroeconomic prediction, (ii) the standard factor model remains the best regularization, (iii) cross-validations are not all made equal (but K-fold is as good as BIC) and (iv) one should stick with the standard L2 loss. The forecasting gains of nonlinear techniques are associated with high macroeconomic uncertainty, financial stress and housing bubble bursts. This suggests that Machine Learning is useful for macroeconomic forecasting by mostly capturing important nonlinearities that arise in the context of uncertainty and financial frictions.

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