Why You Should Use the Hodrick-Prescott Filter – at Least to Generate Credit Gaps

24 Pages Posted: 30 Oct 2018

See all articles by Mathias Drehmann

Mathias Drehmann

Bank for International Settlements (BIS)

James Yetman

Bank for International Settlements (BIS)

Date Written: August 13, 2018

Abstract

The credit gap, defined as the deviation of the credit-to-GPD ratio from a Hodrick-Prescott (HP) filtered trend, is a powerful early warning indicator for predicting crises. Basel III therefore suggests that policymakers should use it as part of their countercyclical capital buffer frameworks. Hamilton (2017), however, argues that you should never use an HP filter as it results in spurious dynamics, has end-point problems and its typical implementation is at odds with its statistical foundations. Instead he proposes the use of linear projections. Some have also criticised the normalisation by GDP, since gaps will be negatively correlated with output. We agree with these criticisms. Yet, in the absence of clear theoretical foundations, all proposed gaps are but indicators. It is therefore an empirical question which measure performs best as an early warning indicator for crises – the question we address in this paper. We run a horse race using quarterly data from 1970 to 2017 for 42 economies. We find that no other gap outperforms the baseline credit-to-GDP gap. By contrast, credit gaps based on linear projections in real time perform poorly.

Keywords: early warning indicators; credit gaps; HP filter

JEL Classification: E44, G01

Suggested Citation

Drehmann, Mathias and Yetman, James, Why You Should Use the Hodrick-Prescott Filter – at Least to Generate Credit Gaps (August 13, 2018). BIS Working Paper No. 744, Available at SSRN: https://ssrn.com/abstract=3275756

Mathias Drehmann (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

James Yetman

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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