A Near Optimal Test for Structural Breaks When Forecasting Under Square Error Loss

TI 2017-039/III Tinbergen Institute Discussion Paper

56 Pages Posted: 19 Apr 2017

See all articles by Tom Boot

Tom Boot

University of Groningen

Andreas Pick

Erasmus University Rotterdam (EUR) - Department of Econometrics; De Nederlandsche Bank

Date Written: April 12, 2017

Abstract

We propose a near optimal test for structural breaks of unknown timing when the purpose of the analysis is to obtain accurate forecasts under square error loss. A bias-variance trade-off exists under square forecast error loss, which implies that small structural breaks should be ignored. We study critical break sizes, assess the relevance of the break location, and provide a test to determine whether modeling a break will improve forecast accuracy. Asymptotic critical values and near optimality properties are established allowing for a break under the null, where the critical break size varies with the break location. The results are extended to a class of shrinkage forecasts with our test statistic as shrinkage constant. Empirical results on a large number of macroeconomic time series show that structural breaks that are relevant for forecasting occur much less frequently than indicated by existing tests.

Keywords: structural break test, forecasting, squared error loss

JEL Classification: C12, C53

Suggested Citation

Boot, Tom and Pick, Andreas, A Near Optimal Test for Structural Breaks When Forecasting Under Square Error Loss (April 12, 2017). TI 2017-039/III Tinbergen Institute Discussion Paper , Available at SSRN: https://ssrn.com/abstract=2954468 or http://dx.doi.org/10.2139/ssrn.2954468

Tom Boot (Contact Author)

University of Groningen ( email )

P.O. Box 800
9700 AH Groningen, Groningen 9700 AV
Netherlands

Andreas Pick

Erasmus University Rotterdam (EUR) - Department of Econometrics ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

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