## 5.9 Correlation, causation and forecasting

### Correlation is not causation

It is important not to confuse correlation with causation, or causation with forecasting. A variable $$x$$ may be useful for predicting a variable $$y$$, but that does not mean $$x$$ is causing $$y$$. It is possible that $$x$$ is causing $$y$$, but it may be that the relationship between them is more complicated than simple causality.

For example, it is possible to model the number of drownings at a beach resort each month with the number of ice-creams sold in the same period. The model can give reasonable forecasts, not because ice-creams cause drownings, but because people eat more ice-creams on hot days when they are also more likely to go swimming. So the two variables (ice-cream sales and drownings) are correlated, but one is not causing the other. It is important to understand that correlations are useful for forecasting, even when there is no causal relationship between the two variables.

However, often a better model is possible if a causal mechanism can be determined. In this example, both ice-cream sales and drownings will be affected by the temperature and by the numbers of people visiting the beach resort. Again, high temperatures do not actually cause people to drown, but they are more directly related to why people are swimming. So a better model for drownings will probably include temperatures and visitor numbers and exclude ice-cream sales.

### Confounded predictors

A related issue involves confounding variables. Suppose we are forecasting monthly sales of a company for 2012, using data from 2000–2011. In January 2008 a new competitor came into the market and started taking some market share. At the same time, the economy began to decline. In your forecasting model, you include both competitor activity (measured using advertising time on a local television station) and the health of the economy (measured using GDP). It will not be possible to separate the effects of these two predictors because they are correlated. We say two variables are confounded when their effects on the forecast variable cannot be separated. Any pair of correlated predictors will have some level of confounding, but we would not normally describe them as confounded unless there was a relatively high level of correlation between them.

Confounding is not really a problem for forecasting, as we can still compute forecasts without needing to separate out the effects of the predictors. However, it becomes a problem with scenario forecasting as the scenarios should take account of the relationships between predictors. It is also a problem if some historical analysis of the contributions of various predictors is required.

### Multicollinearity and forecasting

A closely related issue is multicollinearity which occurs when similar information is provided by two or more of the predictor variables in a multiple regression. It can occur in a number of ways.

Two predictors are highly correlated with each other (that is, they have a correlation coefficient close to +1 or -1). In this case, knowing the value of one of the variables tells you a lot about the value of the other variable. Hence, they are providing similar information.

A linear combination of predictors is highly correlated with another linear combination of predictors. In this case, knowing the value of the first group of predictors tells you a lot about the value of the second group of predictors. Hence, they are providing similar information.

The dummy variable trap is a special case of multicollinearity. Suppose you have quarterly data and use four dummy variables, $$d_1,d_2,d_3$$ and $$d_4$$. Then $$d_4=1-d_1-d_2-d_3$$, so there is perfect correlation between $$d_4$$ and $$d_1+d_2+d_3$$.

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The dummy variable trap is a special case of multicollinearity, referred to as perfect multicollinearity. Suppose you have quarterly data and use four dummy variables, $$d_1,~d_2,~d_3$$ and $$d_4$$. Then $$d_1+d_2+d_3+d_4=1$$ and therefore there is perfect correlation between the column of ones representing the constant and the linear combination, in this case the sum, of the dummies.

In the case of perfect correlation (i.e., a correlation of +1 or -1, such as in the dummy variable trap), it is not possible to estimate the regression model. If there is high correlation (close to but not equal to +1 or -1), then the estimation of the regression coefficients is computationally difficult. In fact, some software (notably Microsoft Excel) may give highly inaccurate estimates of the coefficients. Most reputable statistical software will use algorithms to limit the effect of multicollinearity on the coefficient estimates, but you do need to be careful. The major software packages such as R, SPSS, SAS and Stata all use estimation algorithms to avoid the problem as much as possible.

The uncertainty associated with individual regression coefficients will be large. This is because they are difficult to estimate. Consequently, statistical tests (e.g., t-tests) on regression coefficients are unreliable. (In forecasting we are rarely interested in such tests.) Also, it will not be possible to make accurate statements about the contribution of each separate predictor to the forecast.

Forecasts will be unreliable if the values of the future predictors are outside the range of the historical values of the predictors. For example, suppose you have fitted a regression model with predictors $$x_1$$ and $$x_2$$ which are highly correlated with each other, and suppose that the values of $$x_1$$ in the fitting data ranged between 0 and 100. Then forecasts based on $$x_1>100$$ or $$x_1<0$$ will be unreliable. It is always a little dangerous when future values of the predictors lie much outside the historical range, but it is especially problematic when multicollinearity is present.

Note that if you are using good statistical software, if you are not interested in the specific contributions of each predictor, and if the future values of your predictor variables are within their historical ranges, there is nothing to worry about — multicollinearity is not a problem.