Dynamic Factors and the Predictability of Consumption Growth

In this paper we study the predictability of aggregate consumption growth using common factors extracted from a large panel of macroeconomic and financial time series. The stochastic process followed by consumption growth and its predictability by other variables is a key assumption in theoretical models in finance such as consumption-based asset pricing models. Research using empirical data to investigate these aspects of consumption growth is sparse. We find that selected dynamic factors are able to explain up to 36% of the consumption growth variability at quarterly frequency using both in-sample and out-of-sample predictive regressions. We find as well that a single common factor, which summarizes short term interest rates and spreads on bond rates, individually accounts for as much as 23% of this variation. We also conduct a battery of robustness check which further support our main conclusion.