Abstract
The paper assesses the impact of adding information on financial cycles on the output gap estimates for eight advanced economies using two unobserved components models: a reduced form extended Hodrick-Prescott filter, and a standard semi-structural unobserved components model. To complement these models, a semi-structural vector autoregression model is proposed in which only supply shocks are identified. The accuracy of the output gap estimates is assessed based on their performance in predicting recessions. The models with financial variables generally produce more accurate output gap estimates at the expense of increased real-time volatility. While the extended Hodrick-Prescott filter is particularly appealing for its real-time stability, it lags behind the two semi-structural models in terms of forecasting performance. The vector autoregression model augmented with financial variables features the best in-sample forecasting performance, and it has similar real-time prediction capabilities to the semi-structural unobserved components model. Overall, financial cycles appear to be relevant in Japan, Spain, the UK, and – to a lesser extent – in the US and in France, while they are relatively muted in Canada, Germany, and Italy.
Highlights
Potential output has been traditionally defined as the maximum level of economic activity attainable without triggering inflation and, in the same context, as the output linked to the level of employment that results in a nonaccelerating rate of inflation (Okun (1962))
The paper assesses the impact of adding information on financial cycles on the output gap estimates for eight advanced economies using two unobserved components models: a reduced form extended Hodrick-Prescott filter, and a standard semi-structural unobserved components model
Start dates range from 1968q4 to 1985q1 depending on the country, while the end date is always 2016q4.8 Gross domestic product, consumer price index and the rate of capacity utilisation are obtained from the OECD Main Indicators database
Summary
Potential output has been traditionally defined as the maximum level of economic activity attainable without triggering inflation and, in the same context, as the output linked to the level of employment that results in a nonaccelerating rate of inflation (Okun (1962)). By taking advantage of its distinct trend-cycle decomposition technique, the semi-structural VAR provides valuable external validation of the results from the other models This cross-check is useful when the results from the other UCMs differ (such as for JP and the US) or the results are sensitive to the priors imposed on the parameters of the model. The semistructural VAR is generally more successful in accurately capturing macroeconomic and financial imbalances than the UCMs. The model features the best in-sample forecasting performance of recession probabilities among all three models, and it has similar real-time prediction capabilities to the semi-structural UCM and clearly superior to the extended HP filter.
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