Improving the Hodrick-Prescott Filter

Abstract

In Chapter 5 we saw that the filter implies large revisions for recent periods (roughly, for the last two years). The imprecision in the cycle estimator for the last quarters implies, in turn, a poor performance in early detection of turning points. Furthermore, as was just mentioned, direct inspection of Figure 5.3 shows another limitation of the HP filter: the cyclical signal it provides seems rather uninformative. Seasonal variation has been removed, but a large amount of noise remains in the signal, making its reading and the dating of turning points difficult. In the next two sections, we proceed to show how these two shortcomings can be reduced with some relatively simple modifications.