Time-varying Factor Augmented Vector Autoregression with Grouped Sparse Autoencoder

Abstract: Recent economic events, including the global financial crisis and COVID-19 pandemic, have exposed limitations in linear Factor Augmented Vector Autoregressive (FAVAR) models for forecasting and structural analysis. Nonlinear dimension techniques, particularly autoencoders, have emerged as promising alternatives in a FAVAR framework, but challenges remain in identifiability, interpretability, and integration with traditional nonlinear time series methods. We address these challenges through two contributions. First, we introduce a Grouped Sparse autoencoder that employs the Spike-and-Slab Lasso prior, with parameters under this prior being shared across variables of the same economic category, thereby achieving semi-identifiability and enhancing model interpretability. Second, we incorporate time-varying parameters into the VAR component to better capture evolving economic dynamics. Our empirical application to the US economy demonstrates that the Grouped Sparse autoencoder produces more interpretable factors through its parsimonious structure; and its combination with time-varying parameter VAR shows superior performance in both point and density forecasting. Impulse response analysis reveals that monetary policy shocks during recessions generate more moderate responses with higher uncertainty compared to expansionary periods.