An approach for identifying and predicting economic recessions in real‐time using time–frequency functional models

Identifying periods of recession and expansion is a challenging topic of ongoing interest with important economic and monetary policy implications. Given the current state of the global economy, significant attention has recently been devoted to identifying and forecasting economic recessions. Consequently, we introduce a novel class of Bayesian hierarchical probit models that take advantage of dimension‐reduced time–frequency representations of various market indices. The approach we propose can be viewed as a Bayesian mixed frequency data regression model, as it relates high‐frequency daily data observed over several quarters to a binary quarterly response indicating recession or expansion. More specifically, our model directly incorporates time–frequency representations of the entire high‐dimensional non‐stationary time series of daily log returns, over several quarters, as a regressor in a predictive model, while quantifying various sources of uncertainty. The necessary dimension reduction is achieved by treating the time–frequency representation (spectrogram) as an “image” and finding its empirical orthogonal functions. Subsequently, further dimension reduction is accomplished through the use of stochastic search variable selection. Overall, our dimension reduction approach provides an extremely powerful tool for feature extraction, yielding an interpretable image of features that predict recessions. The effectiveness of our model is demonstrated through out‐of‐sample identification (nowcasting) and multistep‐ahead prediction (forecasting) of economic recessions. In fact, our results provide greater than 85% and 80% out‐of‐sample forecasting accuracy for recessions and expansions respectively, even three quarters ahead. Finally, we illustrate the utility and added value of including time–frequency information from the NASDAQ index when identifying and predicting recessions. Copyright © 2012 John Wiley & Sons, Ltd.