Fractional trends and cycles in macroeconomic time series

TL;DR

This paper introduces a fractional trend-cycle decomposition model for macroeconomic time series that estimates the degree of persistence without prior assumptions, resulting in more accurate trend and cycle analysis.

Contribution

The paper develops a novel fractional integrated model with a modified Kalman filter, allowing endogenous estimation of persistence and improved trend-cycle separation in macroeconomic data.

Findings

The model estimates smooth trends aligned with recessions.

It reduces upward bias in signal-to-noise ratio for persistent data.

Produces more realistic cycle and trend estimates than $I(1)$ models.

Abstract

We develop a generalization of correlated trend-cycle decompositions that avoids prior assumptions about the long-run dynamic characteristics by modelling the permanent component as a fractionally integrated process and incorporating a fractional lag operator into the autoregressive polynomial of the cyclical component. The model allows for an endogenous estimation of the integration order jointly with the other model parameters and, therefore, no prior specification tests with respect to persistence are required. We relate the model to the Beveridge-Nelson decomposition and derive a modified Kalman filter estimator for the fractional components. Identification, consistency, and asymptotic normality of the maximum likelihood estimator are shown. For US macroeconomic data we demonstrate that, unlike $I(1)$ correlated unobserved components models, the new model estimates a smooth trend together with a cycle hitting all NBER recessions. While $I(1)$ unobserved components models yield an upward-biased signal-to-noise ratio whenever the integration order of the data-generating mechanism is greater than one, the fractionally integrated model attributes less variation to the long-run shocks due to the fractional trend specification and a higher variation to the cycle shocks due to the fractional lag operator, leading to more persistent cycles and smooth trend estimates that reflect macroeconomic common sense.