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Why you should use the Hodrick-Prescott filter - at least to generate credit gaps

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  • Mathias Drehmann
  • James Yetman

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.

Suggested Citation

  • Mathias Drehmann & James Yetman, 2018. "Why you should use the Hodrick-Prescott filter - at least to generate credit gaps," BIS Working Papers 744, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:744
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    References listed on IDEAS

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    More about this item

    Keywords

    early warning indicators; credit gaps; HP filter;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises

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