Forecasting euro area recessions by combining financial information

The last two macroeconomic recessions in the euro area in 2008-2009 and 2011-2013 have pointed out the impact of financial markets on economic activity. In this paper, we propose to evaluate the ability of a set of financial variables to forecast recessions in the euro area by using binary response models associated with information combination. For various forecast horizons, we provide a readable and leading signal of recession by combining information according to two combining schemes. First we average recession probabilities and second we linearly combine variables through a factor model in order to estimate an innovative Factor-Augmented probit model. Out-of-sample results over the periods 2007-2009 and 2011-2013 show that financial variables would have been helpful in giving accurate and timely recession signals in real-time.