Finance and Economics Discussion Series (FEDS)
When Can Trend-Cycle Decompositions Be Trusted?
In this paper, we examine the results of GDP trend-cycle decompositions from the estimation of bivariate unobserved components models that allow for correlated trend and cycle innovations. Three competing variables are considered in the bivariate setup along with GDP: the unemployment rate, the inflation rate, and gross domestic income. We find that the unemployment rate is the best variable to accompany GDP in the bivariate setup to obtain accurate estimates of its trend-cycle correlation coefficient and the cycle. We show that the key feature of unemployment that allows for precise estimates of the cycle of GDP is that its nonstationary component is "small" relative to its cyclical component. Using quarterly GDP and unemployment rate data from 1948:Q1 to 2015:Q4, we obtain the trend-cycle decomposition of GDP and find evidence of correlated trend and cycle components and an estimated cycle that is about 2 percent below its trend at the end of the sample.
Keywords: Unobserved components model, trend-cycle correlation, trend-cycle decomposition
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