Trends, Cycles and Autoregressions

Author(s): Andrew Harvey

Source: The Economic Journal, Vol. 107, No. 440 (Jan., 1997), pp. 192-201
Published by: Blackwell Publishing for the Royal Economic Society
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The EconomicJournal, 107 (January), I92-201. ? Royal Economic Society I997. Published by Blackwell
Publishers, io8 Cowley Road, Oxford OX4 iJF, UK and 238 Main Street, Cambridge, MA 02I42, USA.

TRENDS, CYCLES AND AUTOREGRESSIONS*

AndrewHarvey

A casual inspection of many economic time series shows that they have trends.
It is equally apparent that, unless the time period is fairly short, these trends
cannot be adequately captured by straight lines. In other words, a deterministic
linear time trend is too restrictive.Despite this, a good deal of applied economic
work starts off by detrending the data by regressingon time, thereby rendering
all that follows invalid. In recent years, it has become fashionable to detrend
using the Hodrick-Prescott filter. This allows the researcher to commit the
same mistake in a more sophisticated way.
Separating out the trend from the cycle is motivated by the idea that the
economic theory which is relevant to the long run is different to the theory one
wishes to apply in the short run. Irrespective of whether or not one accepts this
view, an arbitrary separation into trend and cycle is clearly not to be
recommended. The ideal way to proceed is by constructing a multivariate
model using original data. If this proves too difficult, one should at least begin
by separating out the long run in a way which pays attention to the properties
of series.
The first section looks at univariate models and discusses the way in which
various formulations provide information about the long run. The next section
looks at seasonality to make the point that seasonal effects are correctly viewed
as a permanent component of a time series. Having established the background,
multivariate models are discussed. I argue that the current fad for basing all
dynamic econometrics on autoregressionsis unfortunate. It can be misleading;
it can focus attention on uninteresting questions; and it can detract from
potentially more fruitful approaches.

I. UNIVARIATE SERIES
I will start off on a positive note by saying what I think should be done. This
puts me in a clearer position to say what should not be done.

StructuralTimeSeriesModels
Since a deterministic time trend is too restrictive, the obvious thing to do is to
make it more flexible by letting the level and slope parameters change over
time. In a structural time series model, these parameters are essentially
assumed to follow random walks. This leads to a stochastic trend in which the

* I am grateful to Danny Quah, Andrew Scott, Robert Taylor and Arnold Zellner for helpful comments.
Of course it goes without saying that I am solely responsible for the views expressed here. I would also like
to thank the ESRC for support under the grant 'Interrelationships in Economic Time Series', Rooo 23 5330.
The article was written while I was in the Department of Statistics at the London School of Economics.
[ I92 ]
[JAN. I997] TRENDS, CYCLES AND AUTOREGRESSIONS I93
level and slope are allowed to evolve over time. The forecasts from such a model
put more weight on the most recent observations; the faster the level and slope
change, the more past observations are discounted. The deterministic trend is
a limiting case in which the hyperparameters which allow the level and slope
to change are equal to zero. Other components can be added to the model in
addition to the trend and irregular. In particular we may wish to include a
cycle and a seasonal. As with the trend, both these components are stochastic,
but each becomes deterministic as a limiting case. The whole model is therefore
set up in terms of components which have a direct interpretation. In
conventional econometric terms it can be thought of simply as a regression
model in which the explanatory variables are functions of time and the
parameters are time-varying.
The forecasts in a structural time series model are constructed automatically
by the Kalman filter. The trend is extracted by a smoothing algorithm. The
parameters which govern the evolution of the trend are estimated by maximum
likelihood, again using the Kalman filter. Thus the whole model is handled
within a unified statistical framework which produces optimal estimates with
well defined properties. These procedures have been implemented in user
friendly form in the STAMP package of Koopman et al. (I995). It is not
necessary to understand the Kalman filter in order to use the package. This
means that the applied economist is free to concentrate on the selection of a
suitable model and its interpretation.
Traditional time series analysis stresses the role of differencing in constructing
models for non-stationary time series. Although structural time series models
can be represented in differences, and hence specified from an analysis of a
suitably differenced series, it is not usually necessary to difference in order to
specify a suitable model. Working in levels makes interpretation much easier.
The properties of most economic time series are such that models designed to
capture their salient features will usually be perfectly satisfactory. The validity
of a model can be assessed not only by looking at diagnostic statistics, but also
by seeing if the estimated components are sensible.

ARIMA Models
The traditional way of time series modelling is based on the Box-Jenkins
methodology of identifying an autoregressive-integrated-moving average
(ARIMA) model by differencing to obtain a stationary series and then using
tools such as the sample autocorrelation function to select the order of the
autoregressive and moving average parts. Many economists are suspicious of
ARIMA modelling because it seems like a 'black box'. They are quite right to
be so.
There are two major objections to the ARIMA approach. The first concerns
the model selection methodology. As a general procedure it simply does not
work. In their book, Box and Jenkins (I976) stressed that the methods they
were proposing were primarily for the identification of simple models in large
samples. With several hundred observations, someone who has studied time
series analysis can reasonably be expected to look at the correlogram and
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194 THE ECONOMIC JOURNAL [JANUARY

correctly identify an AR(i), an MA(2) or perhaps even an ARMA (i, i)

process.1But what about more complex models in small samples? Even with
autocorrelation function of, for example, an
the skill to recognise the theoretical
ARMA(3, 2) process, it is almost impossible to identify such a processfrom the
sampleautocorrelation function. If the series is non-stationary, so that analysis
is based on a differenced series, the selection of an inappropriate model
can have serious consequences for forecasting. Attempting to alleviate the
difficulties of model selection by using an automatic procedure based on a
goodness of fit criterion, such as the Akaike Information Criterion, is of little
help and can often make matters worse.
The second objection concerns the class of ARIMA models itself. There are
those who, despite their initial misgivings, feel they should persevere with
ARIMA models, since they believe there is a mathematical theorem which says
that all series are generated by processes of this kind and it is only a matter of
searching to find the correct one. Of course, there is no such theorem. There
are results that tell us that a (linear) stationary process can be represented to
a desired level of accuracy by an ARMA model, but to jump from this to an
assumption that such models are appropriate for modelling series in the real
world, particularly after differencing, is not tenable. So why do some ARIMA
models forecast well in practice? The question is best answered by referring
back to structural time series models. Linear structural models have ARIMA
reduced forms, that is models which have the same autocorrelation functions
after differencing and give the same forecasts. The principal structural models
have reduced forms such as ARIMA (o, i, i), ARIMA (o, 2, 2) and something
which is very close to seasonal ARIMA (o, i) i) x (o, i, i)s, the 'airline'
model.2 These are the models which tend to be selected in practice by those
who are reasonably competent. They work precisely because they are capturing
the features we know to be characteristicof economic time series such as slowly
changing trends and seasonals. Indeed it is clear, from reading their book, that
this was why Box and Jenkins were led to consider ARIMA models in the first
place, though their reasoning was framed in terms of exponential smoothing
procedures rather than structural models. The problem with the ARIMA class
is that there are many models and parameter values which have no sensible
interpretation and give forecast functions which may have undesirable
properties. Given the model selection difficulties outlined in the previous
paragraph, such models might well be chosen. As an example, Harvey and
Jaeger (I993) fitted a stochastic trend plus cycle model to US GNP. This has
an ARIMA (2, 2, 3) reduced form, but standard Box-Jenkins methodology
leads to the identification of ARIMA (i, i, o). While this has the virtue of
parsimony and forecasts reasonably well over a short time horizon, it cannot
generate the cyclical movements which are a crucial feature of the series.
1 An ARMA (p, q) process is defined as Yt= ...
OiYt-i + ***+ SZiYt-V+ 6t + 01et-1+ ** + Se et-a) t = I, , T,
where t is serially uncorrelated with mean zero and constant variance. It is usually assumed to be normally
distributed.
2
An ARMA(p, d, q) process is one in which the dth differences of the observations follow an
ARMA(p, q) process. For the definition of a multiplicative seasonal ARIMA process, such as the airline
model, see Box and Jenkins (I 976).
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I997] TRENDS, CYCLES AND AUTOREGRESSIONS 195

Supporters of the ARIMA approach argue against structural models on the

grounds that one should: 'Let the data speak for themselves'. But the
information in the data can only be brought out if the class of models is one
which helps to channel this information in the right direction. The unrestricted
ARIMA class does not do this in general. This is especially true if it is important
to deal effectively with the long-run. One solution might be to restrict the
ARIMA class to those models with some interpretation, but, as the example of
US GNP shows, this may not be easy since a relatively complicated ARIMA
model may be needed. In simpler situations, where perhaps an ARIMA
(O, I, i) model or the airline model is appropriate, it is difficult to seen what
possible advantage there is over the corresponding structural model. The
obvious course of action is therefore to use structural models in the first place.3
A final point about ARIMA models concerns estimation of the trend.
Assuming an ARIMA model has certain properties, a trend can be extracted
by the 'canonical decomposition' in which the variance of the irregular
component is maximised. This has the unfortunate property that it removes an
irregular component from a random walk. The other way of proceeding is by
the Beveridge-Nelson decomposition. This can be applied to any ARIMA
model, but even if the ARIMA model is a sensible one, the Beveridge-Nelson
trend will tend to be less satisfactory than a trend obtained from a structural
model since it is a (one-sided) filter rather than a smoother; see Harvey (i 989,
pp. 288-9). In other words it estimates the trend based only on past and
current observations.

Detrending
Despite the differences in the structural and ARIMA approaches, they share
the important similarity that they are based on fitting a model using well-
defined statistical procedures. This is not true of most detrending procedures.
There is little to add as to why a deterministic linear trend is not generally
appropriate, except to note that Nelson and Kang (I98I) have shown that it
can induce spurious cycles. Some econometricians have advocated the
acquiring of additional flexibility by introducing breaks, to give a piecewise
linear trend. This has the advantage that it can be estimated by regression. The
disadvantages are that the break points are assumed to be known and forecast
mean square errors do not allow for the possibility of further breaks. The merit
of the stochastic trend model is that it will adapt to a break whenever it occurs
and the forecast mean square error will reflect the possibility of similar breaks
in the future.
The Hodrick-Prescott (HP) filter produces a very plausible trend-cycle
decomposition for US GNP. In fact Harvey and Jaeger (I993) show that it
corresponds almost exactly to the one produced by fitting a trend plus cycle
structural model. However, the HP filter is widely applied to many other series

3 It should perhaps be stressedthat the structuralclass of models is not less general than the ARIMA class,
because it can be extended to handle situations which are difficult to deal with in the ARIMA framework.
A recent illustration can be found in the paper by Harvey et al. (I996) on the modelling and seasonal
adjustment of weekly money supply figures.
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for which it is completely inappropriate. Such series not only include price
levels, as in Kydland and Prescott (i990), but also GNP for countries other
than the United States. At the theoretical level, it can be shown to produce a
spurious cycle when applied to a random walk. This is an example of the effect
to which Yule and Slutsky drew attention over fifty years ago. It is somewhat
surprising that many modern economists still have not got the message.

Autoregressions
Autoregressive models are widely used by economists because they are easy to
fit by standard regression packages. For a series which is known to be stationary
fitting an autoregressive model is quite a sensible way to proceed. When a series
has to be differenced to make it stationary, fitting an autoregression is often a
disaster. If a series contains a trend component in which the level or slope is
slowly changing, the corresponding ARIMA model will be close to non-
invertibility.' This means that unless a large number of lags are included, an
autoregression will be a very poor approximation. The situation becomes even
worse when the series contains another slowly changing component, such as a
seasonal (which I discuss later).
Even when an autoregressive model does give a good fit, it still suffers from
the disadvantage that it has no interpretation and contains little useful
information; see the case cited earlier of modelling US GNP by an AR(i) in
first differences. Autoregressive modelling is even more of a black box than
ARIMA modelling, the only attraction being that it apparently requires very
little knowledge of time series analysis.

Unit Roots
Testing for unit roots has become almost mandatory in applied economics. This
is despite the fact that, much of the time, it is either unnecessary or misleading,
or both. Most unit root tests are based on autoregressive models and they
display poor statistical properties when the autoregressive approximation is a
poor one. As I argued in the previous paragraph, this can be quite often.
Why worry about testing for unit roots in the first place? Nelson and Plosser
(i 982) used unit root tests to show that most economic time series could not be
handled by a deterministic time trend plus a stationary component. This attack
on the so-called trend-stationary model needed to be made because of its wide
acceptance amongst applied economists. But, to many time series analysts,
deterministic trend models are so implausible that they should never be
imposed unless there is very strong supporting evidence for doing so.
Within the structural framework deciding on the degree of integration is not
crucial, because if the slope is deterministic, the parameter which allows it to
change over time will be estimated as zero or close to zero. The same is true of
the level. Thus very little, if anything, is lost by starting off with a general
4 This point can be illustrated most easily with the simplest structural time series model, the local level:
Yt =I t +6t, t =I. ***n T, tt = tt-l + t, where et and qt are mutually and serially uncorrelated disturbances
with zero means and variances rJ2and r- respectively. The process is non-stationary because #t is a random
walk, but differencing once yields a first-ordermoving average. The smaller the signal noise ratio, oJ/o2, the
closer the parameter of this moving average process is to minus one.
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1997] TRENDS, CYCLES AND AUTOREGRESSIONS 197
stochastic trend model which has the deterministic slope and level as special
cases. If there really is a need to test whether a component can be treated as
deterministic, it is better to use a test which is not based on the autoregressive
approximation. A further issue concerns the use of the 'smooth trend' model
in which the hyperparamater governing changes in the level is set to zero but
that on the slope is not. This model is quite attractive because there are
sometimes good reasons for feeling that the trend should be relatively smooth
since it represents long run movements. Such a model is integrated of order
two, that is, it needs to be differenced twice to make it stationary. But when it
is differenced, it is close to non-invertibility. Under these conditions, unit root
tests are virtually incapable of indicating that a process is integrated of order
two; see the simulation evidence in Harvey andJaeger (I993). This is why most
economists apparently believe that real macroeconomic time series are
integrated of order one and construct models on this basis. If a trend is
extracted, say by the Beveridge-Nelson procedure, it will be relatively uneven.
The use of autoregressive models and associated unit root tests forces the
researcher into a specific way of modelling which effectively excludes
forecasting and decomposition procedures which may be more effective and
have a more natural interpretation. This has important practical implications
for economics because, as shown by Watson (i986), autoregressive models
usually imply a higher level of persistence than structural models (or even some
ARIMA models with moving average terms). Consider the following quote
from an article by Perron in Rao (I 994, p. II 3) 'As far as macroeconomic
theories are concerned, the most important implication of the unit root
revolution is that under this hypothesis, random shocks have a permanent
effect on the system.... This implication ... has profound consequences for
business cycle theories. It runs counter to the prevailing view that business
cycles are transitory components about a more or less stable trend path.' A
similar view is expressed by Rao (I 994, p. 3) in his introduction to the volume.
This view is understandable if we only use autoregressivemodels. As a general
proposition it is wrong and is symptomatic of the confusion which the unit root
'revolution' has caused. The point is that a structural model of a real series
such as GNP will typically contain one or two unit roots, but will be perfectly
consistent with a cycle about a more or less stable trend path; again see Harvey
and Jaeger (I993). Trying to draw conclusion about whether the world is
Keynesian or neoclassical on the basis of the presence or otherwise of unit roots
is complete nonsense. Another example of the misleading effect of autoregressive
methodology is the implication, noted by Deaton (i987), that because an
autoregressive model of income implies high persistence, the smoothness of
consumption is inconsistent with the rational expectations-permanent income
hypothesis. With a structural model the combination of a slowly changing
trend and a cycle implies a much smaller persistence and the apparent excess
smoothness paradox disappears.

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II. SEASONALITY
Seasonal effects are part of the long run because a seasonal pattern is projected
indefinitely into the future. Since seasonal patterns can change over time, the
pattern projected into the future, and which sums to zero over any one year
period, should be the estimate of the latest pattern, at the end of the series. A
structural time series model has a stochastic seasonal component which displays
precisely these features. Although a deterministic seasonal is more plausible
than a deterministic trend, it is inadvisable to assume, as many economists do,
that seasonality can be properly captured by a set of seasonal dummies.
It seems self-evident to me that changes in seasonal patterns can occur in
many types of series and that when they do occur they should be regarded as
permanent. For example, as Scott (I995) shows in a most entertaining article,
the way in which we celebrate Christmas has changed quite dramatically over
the years and this has important implications for the seasonal patterns in such
key series as consumption and the money supply. However, some econo-
metricians have argued that a non-stationary seasonal model is implausible on
the grounds that 'winter cannot become summer', and that seasonal effects are
more likely to be stationary. This argument is erroneous because applying a
similar argument to the trend would suggest that we should never use stochastic
trends, that is unit roots, because there is a chance that such models could
generate values of zero for series like GNP! In any case there are now quite a
lot of examples where the role of different seasons does appear to change.
The so-called HEGY test, presented in Hylleberg, Engle, Granger and Yoo
(i990), is an extension of the Dickey-Fuller unit root test which tests the null
of a non-stationary seasonal against the alternative that it is stationary. While
I admire the technical achievement of HEGY, I have always been against using
it, firstly because I think stationary seasonality is rarely appropriate, and
secondly because the test is based on an autoregressive approximation and so
will have the same dreadful properties as standard unit root tests. There is now
a growing body of evidence, including the recent articles by Canova and
Hansen (I995), Harvey and Scott (I994) and Taylor and Leybourne (I995),
supporting this second point.
Those who have found it hard to understand some of the recent literature on
seasonality tests should not worry. The way to treat seasonality is to use a model
which assumes it changes in a permanent way. In the ARIMA framework this
might mean using the airline model, or another model which is similar in
structure insofar as it contains a seasonal difference operator and a seasonal
moving average term. In the structural framework, one simply includes a
stochastic seasonal component. If the seasonal pattern is, in fact, constant, very
little is lost in terms of efficiency provided initial conditions are dealt with
properly; the argument is set out in detail in the appendix to Harvey and Scott
(I 994) E

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I997] TRENDS, CYCLES AND AUTOREGRESSIONS 199

III. MULTIVARIATE SERIES

Faced with several time series, many applied economists resort to fitting a
vector autoregression. Such a model is usually called a VAR. To many
econometricians, VAR stands for 'Very Awful Regression'. (I am indebted to
Arnold Zellner for introducing me to this delightful terminology.) Although
they are easy to fit, and can be used as a crude forecasting device, vector
autoregressions tell us little about economics. However, they become a little
more respectable if modified in such a way that they can embody co-
integration restrictions which reflect long run equilibrium relationships. The
vector error correction mechanism (VECM) has been very influential in this
respect as it enables the researcher to make use of the procedure devised by
Johansen (I988) to test for the number of co-integrating relationships. Thus
economists can apparently discover long run relationships in a framework
which does not involve specifying a model based on dubious economic
assumptions. These long run relationships can then be incorporated in
forecasts.
There are a number of reasons why my enthusiasm for VAR-based co-
integration methods is somewhat muted. The fundamental objection is that
autoregressive approximations can be very poor, even if a large number of
parameters is used. One of the consequences is that co-integration tests based
on autoregressive models can, like unit root tests, have very poor statistical
properties. Another is that allowing for series to be integrated of order two,
although technically possible, is even less likely to be successful in practice for
real series for the reasons given earlier. Similarly, it is virtually impossible to fit
an autoregressive model to data with slowly changing seasonality; seasonally
adjusted data is almost always used in practice, though as Maravall (I993) has
recently pointed out autoregressive models are often not even valid in such
cases. The situations in which VECMs can be usefully employed are therefore
limited and I feel very uneasy with the idea that they provide a general vehicle
for modelling economic time series. However, casting these technical
considerations aside, what have economists learnt from fitting such models?
The answer is very little. I cannot think of one article which has come up with
a co-integrating relationship which we did not know about already from
economic theory. Furthermore, when there are two or more co-integrating
relationships, they can only be identified by drawing on economic knowledge.
All of this could be forgiven if the VECM provided a sensible vehicle for
modelling the short run, but it doesn't because vector autoregressions confound
long run and short run effects.
Vector ARIMA models are hopelessly intractable for non-stationary series.
The main reason is that it is difficult to interpret the moving average
parameters and hence place sensible restrictions on them. Multivariate
structural time series models offer an interesting alternative to VECMs. They
are specifically formulated in terms of long and short run components. The
long run components can incorporate co-integration restrictions directly by
means of common trends. The short run can be modelled in a number of ways,
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including a stationary VAR. Gains in efficiency are possible if economic theory

suggests restrictions which can be put on short and long run components.
Including stochastic seasonals and allowing for stochastic slopes, so that trends
can be integrated of order two, is reasonably straightforward. Details can be
found in Harvey and Koopman (I996). The main problem is whether the
numerical optimisation procedures can cope with the required number of time
series. However, there are already a number of successful applications.

IV. CONCLUSION
Many of the horrors perpetrated by applied economists stem from a belief in
the power and generality of regression. Unfortunately regression is simply not
up to it. The distrust in time series models, including ARIMA, which have no
obvious interpretation is well founded. The solution is to combine the flexibility
of a time series model with the interpretation of regression. This is exactly what
is done in the structural time series approach.
The usual way in which regression is combined with time series is by
autoregression. There is no doubt that the simple form of autoregressive models
has provided the key to some fine theoretical work and important insights.
However, autoregressions, whether univariate or multivariate, are very limited
in scope. The recent emphasis on unit roots, vector autoregressions and co-
integration has focused too much attention on tackling uninteresting problems
by flawed methods.
University of Cambridge

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