Markov-switching three-pass regression filter

We introduce a new approach for the estimation of high-dimensional factor models with regime-switching factor loadings by extending the linear three-pass regression filter to settings where parameters can vary according to Markov processes. The new method, denoted as Markov-switching three-pass regression filter (MS-3PRF), is suitable for datasets with large cross-sectional dimensions, since estimation and inference are straightforward, as opposed to existing regime-switching factor models where computational complex-ity limits applicability to few variables. In a Monte Carlo experiment, we study the finite sample properties of the MS-3PRF and find that it performs favorably compared with alternative modeling approaches when-ever there is structural instability in factor loadings. For empirical applications, we consider forecasting economic activity and bilateral exchange rates, finding that the MS-3PRF approach is competitive in both cases. Supplementary materials for this article are available online.