ECONOMETRIC METHODS

OF SIGNAL EXTRACTION
by D.S.G. POLLOCK

University of London
and
GREQAM: Groupement de Recherche en
Economie Quantitative d’Aix–Marseille
Emails: stephen [email protected]

The Wiener–Kolmogorov signal extraction filters, which are widely used in econo-
metric analysis, are constructed on the basis of statistical models of the processes
generating the data. In this paper, such models are used mainly as heuristic de-
vices that are to be specified in whichever ways are appropriate to ensure that the
filters have the desired characteristics. The digital Butterworth filters, which are
described and illustrated in the paper, are specified in this way.
The components of an econometric time series often give rise to spectral
structures that fall within well-defined frequency bands that are isolated from each
other by spectral dead spaces. We find that the finite-sample Wiener–Kolmogorov
formulation lends itself readily to a specialisation that is appropriate for dealing
with band-limited components.

1. Introduction
The econometric methods of signal extraction that are based on linear filters
have attained a high level of sophistication. They have now coalesced into two
distinct categories.
In the first category are the methods that are favoured by the central
statistical agencies of many of the OECD counties. These were developed
in the North American agencies, notably in Statistics Canada (Dagum 1980)
and in the U.S. Bureau of the Census (Findley et al. 1998), and they have
been supported and refined in other agencies throughout Europe and in the
Antipodes.
The methods are based upon a variety of moving-average smoothing filters,
and they are used, principally, in trend extraction and in deseasonalising data
series. Considerable efforts have been devoted to dealing with the end effects
that can arise when such filters are applied to short non-stationary sequences.
The success of the methods of the central statistical agencies has entailed
a widespread acceptance of a set of common conventions and definitions. Thus,
it is commonly agreed that a deseasonalised data series can be fairly and simply
defined as the product of the relevant methods of the central statistical office.
However, the acceptance of such conventions, whilst necessary to ensure
comparability of statistics across nations, inhibits scientific innovation and dis-
covery. Therefore, academic interest has been focused mainly on the so-called
model-based procedures, which constitute the second category of econometric
signal-extraction methodology.

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 D.S.G. POLLOCK: Econometric Signal Extraction

The model-based approaches are derived from the idea that the compo-
nents of an econometric times series, which are its trend, its secular cycles, its
seasonal cycles and its irregular component, can all be modelled by autoregres-
sive integrated moving-average (ARIMA) processes of low orders. There are
several exponents of this genre who have taken slightly different approaches.
In the structural approach, which originated with Harrison and Stevens
(1976) and which has been developed by Harvey (1989) and others, such models
are fitted jointly to the data in a manner that renders their parameters readily
accessible. (These methods have been implemented in the STAMP program of
Koopman et al. 2000.) In the alternative canonical approach, which has been
advocated by Hillmer and Tiao (1982) and by Maravall and Pierce (1987),
amongst others, the models of the individual components must be disentangled
from a fitted ARIMA model that represents their joint effects. (An accessible
implementation is in the SEATS–TRAMO program of Gómez and Maravall,
1994, 1996.)
The model-based procedures have the seeming advantage that they subsist
within a framework that facilitates conventional statistical inference. Thus,
for example, confidence intervals are easily generated that can surround the
estimated data components. However, the validity of such inferences depends
crucially upon the cogency of the linear time-invariant ARIMA models that are
applied to the components. The ability of such models to reflect the underlying
data structures is limited. In particular, the models are liable to be subverted
whenever the structures show any significant tendency to evolve through time.
In this paper, we also use models in deriving the filters that are used to
isolate the data components, but the models will be treated mainly as heuristic
devices that allow us to exploit the mathematical formalisms of the Wiener–
Kolmogorov theory of signal extraction. This theory indicates that the optimal
estimates of the data components are provided by their conditional expectations
that are formed in the light of the observed data and of the models that are
presumed to have generated them.
When the models themselves are to be fitted to the data, it is important
that they should be realistic—otherwise they will provide an insecure basis
for forming the supposedly optimal filters. However, in practice, they rarely
achieve much realism. When the models are used merely as heuristic devices,
they can be specified in whichever ways are appropriate to ensure that the
filters have the desired characteristics. Moreover, the desirable characteristics
will be unaffected, in the main, by the evolutions of the data components that
the resulting filters are designed to isolate.
The original Wiener–Kolmogorov theory was developed under the fictional
assumption that the data are generated by a stationary stochastic process and
that they form a doubly infinite sequence. In econometrics, one has to contend
with short non-stationary sequences; and, to cope with these, it is common to
resort to the Kalman filter.
The Kalman filter and the associated smoothing algorithms are compli-
cated and powerful devices, of which the workings can often seem obscure. The
difficulty can be attributed to the all-encompassing nature of the algorithms.

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 D.S.G. POLLOCK: Econometric Signal Extraction

In this paper, we shall pursue a simpler approach that fulfils the same objec-
tive of obtaining quasi minimum-mean-square-error estimates, but which deals
directly with the specific features of the problem at hand. We shall use the
finite-sample version of the bidirectional Wiener–Kolmogorov filter that has
been expounded in previous papers of the present author (see Pollock, 1997,
2000, 2001, and 2002).
One of the contentions of this paper is that the components of an economet-
ric time series often give rise to spectral structures that fall within well-defined
frequency bands that are isolated from each other by spectral dead spaces. This
leads us to consider the nature of band-limited stochastic processes, which are
characterised by singular dispersion matrices. We find that the finite-sample
Wiener–Kolmogorov formulation lends itself readily to a specialisation that is
appropriate for dealing with band-limited components.

2. Filtering Short Stationary Sequences

We begin by considering the problem of estimating the signal component ξ(t)
and the noise component η(t) of a data sequence

y(t) = ξ(t) + η(t), (1)

where t ∈ {0, ±1, ±2, . . .} is the index of the discrete-time observations. Ac-
cording to the classical assumptions, which we shall later amend in various
ways, the signal and the noise are generated by stationary stochastic processes
that are mutually independent. It follows that the autocovariance generating
function of the data, defined by
∞
X
γ(z) = γ0 + γτ (z τ + z −τ ), (2)
τ =1

is the sum of the autocovariance generating functions of its components. Thus

γ(z) = γξ (z) + γη (z). (3)

In practice, the available data will form a finite sequence which consti-
tutes a vector y = [y0 , y1 , . . . , yT −1 ]0 with a signal component ξ and a noise
component η such that
y = ξ + η. (4)
The data might owe their stationarity to a prior differencing operation or to
an operation that has involved the extraction of a trend from the original data
and the retention of the residue. For these vectors, the moment matrices are

E(ξ) = 0, D(ξ) = Ωξ ,
E(η) = 0, D(η) = Ωη , (5)
and C(ξ, η) = 0.

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 D.S.G. POLLOCK: Econometric Signal Extraction

The independence of ξ and η implies that D(y) = Ω = Ωξ + Ωη .

Here, the various variance–covariance or dispersion matrices, which have
a Toeplitz structure, may be obtained by replacing the argument z within the
relevant generating function by the matrix

LT = [e1 , . . . , eT −1 , 0], (6)

which is obtained from the identity matrix IT = [e0 , e1 , . . . , eT −1 ] by deleting

the leading column and appending a column of zeros to the end of the array.
The matrix LT , which has units on the first subdiagonal and zeros elsewhere,
is the finite-sample version of the lag operator. Using it in place of z in γ(z)
gives
X
T −1
D(y) = Ω = γ0 I + γτ (LτT + FTτ ), (7)
τ =1

where FT = L0T is in place of z −1 . Since LT and FT are nilpotent of degree T ,

such that LqT , FTq = 0 when q ≥ T , the index of summation has an upper limit
of T − 1.
The optimal predictors of the components ξ and η are their conditional
expectations, denoted by x and h, respectively, in (8) and (9):

E(ξ|y) = E(ξ) + C(ξ, y)D−1 (y){y − E(y)}

= Ωξ (Ωξ + Ωη )−1 y = x, (8)
E(η|y) = E(η) + C(η, y)D−1 (y){y − E(y)}
= Ωη (Ωξ + Ωη )−1 y = h. (9)

These are the so-called Wiener–Kolmogorov estimates. They constitute the

minimum-mean-square-error estimates of the components, under the assump-
tion that the specifications in (5) are correct. The assumptions provide a set
of ordinary positive-definite variance–covariance matrices that pertain to con-
ventional linear stochastic processes, which have spectra that extend across the
frequency range.
We should observe that adding the estimates gives

y = x + h, (10)

which is to say that the estimated components add up to the data vector y, as
do the true components ξ and η in equation (4). To calculate the estimates,
we may begin by solving the equation

(Ωξ + Ωη )b = y (11)

for the value of b. Thereafter, we can find

x = Ωξ b and h = Ωη b. (12)

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 D.S.G. POLLOCK: Econometric Signal Extraction

The solution to equation (11) may be found via a Cholesky factorisation that
sets Ωξ +Ωη = GG0 , where G is a lower-triangular matrix. The system GG0 b = y
may be cast in the form of Gp = y and solved for p. Then G0 b = p can be
solved for b.
The solution via the Cholesky decomposition constitutes a recursive bidi-
rectional filtering process that generates the vector b via two passes running
in opposite directions through the data. The vector p is the product of a pass
that runs forwards in time, and the vector b is generated from p in a reverse-
time pass. Then b is subjected to further non-recursive filtering operations,
described by (12), which produce x and h.
Exactly the same results would be obtained, albeit in a more complicated
way, by using the Kalman filter, in a forwards pass, and an associated smoothing
algorithm, in a backwards pass. (For an exposition of the latter procedures,
see, for example, Pollock 2003c, where the method of Ansley Kohn 1985 for
initiating the recursions is also analysed.)
It is notable that the recursive filter weights that are provided by the rows
of the matrices G and G0 vary as the filter progresses through the sample. As the
sample size increases, the weights in the final rows of G will tend asymptotically
to the set of constant weights that would be derived under the assumption of
a doubly-infinite data sequence.
In some small-sample implementations of the Wiener–Kolmogorov filter,
a set of constant weights has been applied to data samples that have been
extended at either end by backcasting and forecasting. The additional extra-
sample values have been used in a run-up to the filtering process wherein the
filter is stabilised by providing it with a plausible presample history, if it is
working in the direction of time, or with a plausible post-sample future, if it is
working backward in time. The manner of treating the end-of sample problem
that is implicit in constructions presented here has the theoretical sanction that
it conforms with the theory of minimum-mean-square-error prediction in finite
samples.
The Wiener–Kolmogorov principle of signal extraction is the foundation of
the model-based methods of unobserved components analysis that are nowadays
in widespread use. The parameters of the filters are determined in the process
of fitting ARIMA models to the data components. However, the principle also
supports a variety of heuristic filters of which the parameters are determined
by rule of thumb or in view of the desired characteristics of their frequency
response functions.
Amongst such heuristic filters is the digital version of the Butterworth
filter, which has been advocated by Pollock (1997, 1999, 2000, 2001a, 2001b).
The frequency response of the filter is maximally flat in the vicinity of the zero
frequency and it has a transition band, centered on a chosen cut-off frequency,
that can be narrowed by increasing the filter order. (Gómez 2001 has also
advocated the Butterworth filter, but he has widened its definition to include
filters, such as the filter of Hodrick and Prescott 1997, that do not share the
property of maximal flatness.)
The Butterworth filter, which is of the lowpass Wiener–Kolmogorov va-

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 D.S.G. POLLOCK: Econometric Signal Extraction

11.5

11

10.5

10
0 50 100 150
Figure 1. The quarterly series of the logarithms of consumption in the U.K., for the
years 1955 to 1994, with a linear function interpolated by least-squares regression.

0.15
0.1
0.05
0
−0.05
−0.1

0 50 100 150
Figure 2. The residuals obtained by fitting a linear trend through the logarithmic
consumption data of Figure 1.

0.01

0.0075

0.005

0.0025

0
0 π/4 π/2 3π/4 π
Figure 3. The periodogram of the residuals obtained by fitting a linear trend through
the logarithmic consumption data of Figure 1. The gain of the lowpass Butterworth
filter of order n = 6 and with a cut-off frequency of π/4 is represented by the dotted
line. (The gain is unity at zero frequency.)

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 D.S.G. POLLOCK: Econometric Signal Extraction

riety, originates in a function that is the ratio of two quasi autocovariance

generating functions:

σξ2 γξ (z)
ψ(z) =
σξ2 γξ (z) + ση2 γη (z)
(13)
(1 + z)n (1 + z −1 )n
= .
(1 + z)n (1 + z −1 )n + λ(1 − z)n (1 − z −1 )n

(Here, the normalised autocovariance functions γξ (z) and γη (z), which are au-
tocorrelation functions in other words, need to be scaled by the factors σξ2 and
ση2 respectively, which stand of the variances of the white-noise processes from
which the signal and the noise components are supposedly derived by linear
filtering.)
The autocovariance generating functions relate to an heuristic statistical
model as opposed to a realistic one. The denominator function γ(z) = σξ2 γξ (z)+
ση2 γη (z) stands in place of that of the data process and the numerator function
σξ2 γξ (z) corresponds to that of the signal. Here, λ = ση2 /σξ2 = {1/ tan(ωC /2)}2n
incorporates the nominal cut-off frequency of ωC . By setting z = LT and
z −1 = FT in the numerator and the denominator of ψ(z), we derive the matrices
Ωξ and Ωξ + Ωη , respectively, which can be entered into equation (8).
To derive the two unidirectional filters, the rational function is factorised
as ψ(z) = β(z)β(z −1 ), where β(z), which relates to the direct-time filter, con-
tains the poles that lie outside the unit circle, and β(z −1 ), which relates to
the reverse-time filter, contains the poles that lie inside the circle. This fac-
torisation is described as the Cramér–Wold decomposition. In the case of the
Butterworth filter, analytic expressions for the roots of both the denominator
and the numerator, i.e the poles and the zeros of the filter, are available. The
roots of the denominator have been given by Pollock (2000).
For most other Wiener–Kolmogorov filters specified in the manner of the
Butterworth filter, it is necessary to use an iterative procedure for finding the
Cramér–Wold decomposition. (See for, example Pollock 2003b.) The algorithm
of Wilson (1969), which is based on the Newton–Raphson procedure, is an
effective way of achieving the factorisation; and versions which are coded in C
and in P ascal have been provided by Pollock (1999). (See, also, Laurie 1980,
1982.)
There can be a reasonable objection to the assumption that the data com-
ponents are generated by ordinary linear stochastic processes that comprise the
full range of frequencies from zero up to the limiting Nyquist frequency of π
radians per period. (In discretely sampled systems, the frequencies in excess of
the Nyquist value will be aliased by frequencies within the interval [0, π].) We
shall illustrate the grounds for questioning the assumption via an analysis of a
leading economic index.
Example 1. Figure 1 show the logarithms of the quarterly consumption data
for the U.K. for the years 1955–1994, through which a linear trend has been
interpolated by least-squares regression. When a quadratic polynomial trend
was fitted, it was discovered that the coefficient associated with t2 was not

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 D.S.G. POLLOCK: Econometric Signal Extraction

significantly different from zero. This implies that, over the years in question,
the underlying growth of the economy was at a constant exponential rate. The
residual deviations from the trend, which are shown in Figure 2, represent a
variable multiplicative factor by which underlying trend is modulated; and the
residuals reveal both secular and seasonal variations in consumption.
The periodogram of the residuals is shown in Figure 3. This has a low-
frequency spectral structure, which extends no further than the frequency value
of π/8. The remainder of the periodogram shows a dead space that is punctu-
ated by tall spikes in the vicinities of the frequencies of π/2 and π. The first
of these spikes corresponds to the fundamental frequency of the seasonal fluc-
tuations that play on the back of the more gentle variations that surround the
ascending line in Figure 1. The spike at π is corresponds to the first harmonic
of the seasonal frequency.
The low-frequency structure of Figure 3, which occupies the frequency
interval [0, π/8], can be isolated successfully by any of a wide variety of filters.
All that is required of such a filter is that its transition from pass band to
stop band occurs within the spectral dead space that stretches from π/8 to the
vicinity of π/2, where the spectral structure of the seasonal fluctuations is first
encountered. The Butterworth filter of order n = 6 with a cut off frequency of
π/4 fulfils this requirement. Its frequency response function is superimposed
on Figure 3.
A more exacting task is the extraction of the low-frequency components
from data that is observed at monthly intervals. In that case, the fundamental
seasonal frequency is at π/6 and the transition of the filter must occur within
a correspondingly reduced interval.
The sharpening of the transition can be achieved by raising the order
n of the filter. However, a sharp transition in the low frequency range can be
achieved with a recursive Wiener–Kolmogorov filter only at the cost of bringing
the poles of the filter into close proximity with the perimeter of the unit circle.
This can lead to problems of filter instability, which include the propagation
of numerical rounding errors and the prolongation of the transient effects of
ill-chosen start-up conditions.
These problems have been addressed within the context of the Wiener–
Kolmogorov specification by Pollock (2003b). Alternative specifications for
recursive filters have been investigated in Pollock (2003a). In the next section,
we shall also deal with the problems of “sharp filtering” within the context of
the Wiener–Kolmogorov theory; but we shall forsake the method of recursive
filtering in favour of a method based on Fourier analysis.

3. Filtering via Circulant Matrices

A finite-sample analogue of a stationary stochastic process is a circular or pe-
riodic process y(t) = {yt ; t = 0, ±1, ±2, . . .} that is completely specified by its
values at T consecutive points such that yt = yt mod T . For such processes, the
lag operator is replaced by the circulant matrix

KT = [e1 , . . . , eT −1 , e0 ], (14)

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 D.S.G. POLLOCK: Econometric Signal Extraction

0.15
0.1
0.05
0
−0.05
−0.1

0 50 100 150
Figure 4. The low-frequency component of the consumption residuals of Figure 2.
The component has been extracted by applying a lowpass Butterworth filter of order
n = 6 with a cut off point at ωc = π/4.

0.06
0.04
0.02
0
−0.02
−0.04
−0.06

0 50 100 150
Figure 5. The component extracted from the consumption residuals by applying a
highpass Butterworth filter of order 6 with a cut off point at ωc = π/4.

0.04
0.02
0
−0.02
−0.04
−0.06

0 50 100 150
Figure 6. The seasonal component of the consumption residuals, synthesised from
the Fourier ordinates in the vicinities of π/2 and π .

9
 D.S.G. POLLOCK: Econometric Signal Extraction

which is formed from the identity matrix IT by moving the leading vector to
the back of the array.
This operator effects the cyclic permutation of the elements of any (col-
umn) vector of order T . The matrix is T -periodic such that K q+T = K q .
Whereas LT y = [0, y0 , . . . , yT −2 ] is obtained from y = [y0 , y1 , . . . , yT −1 ] by
deleting the final element and placing a zero in the leading position, the vector
KT y = [yT −1 , y0 , . . . , yT −2 ] is obtained from y by moving the final element to
the leading position.
The powers of K form the basis for the set of circulant matrices. In
particular, we may define a matrix of circular autocovariances via the formula

D◦ (y) = Ω◦ = γ(K)
∞
X
= γ0 I + γτ (K τ + K −τ )
τ =1 (15)
X
T −1
= γ0◦ I + γτ◦ (K τ + K −τ ).
τ =1

Here, γτ◦ ; τ = 0, . . . , T − 1 are the circular autocovariances defined by

∞
X
γτ◦ = γ(jT +τ ) . (16)
j=0

The matrix operator K has a spectral factorisation, which is particularly

useful in analysing the properties of the discrete Fourier transform. The basis
of this factorisation is the so-called Fourier matrix. This is a symmetric matrix

U = T −1/2 [W jt ; t, j = 0, . . . , T − 1], (17)

of which the generic element in the jth row and tth column is

W jt = exp(−i2πtj/T ) = cos(ωj t) − i sin(ωj t),

(18)
where ωj = 2πj/T.

The matrix U is a unitary, which is to say that it fulfils the condition

Ū U = U Ū = I, (19)

where Ū = T −1/2 [W −jt ; t, j = 0, . . . , T − 1] denotes the conjugate matrix.

The operator K can be factorised as

K = Ū DU = U D̄Ū , (20)

where
D = diag{1, W, W 2 , . . . , W T −1 } (21)

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 D.S.G. POLLOCK: Econometric Signal Extraction

is a diagonal matrix whose elements are the T roots of unity, which are found
on the circumference of the unit circle in the complex plane. Observe also that
D is T -periodic, such that Dq+T = Dq , and that K q = Ū Dq U = U D̄q Ū for
any integer q.
The spectral factorisation of the circulant autocovariance matrix gives

Ω◦ = γ(K) = Ū γ(D)U. (22)

Here, the jth element of the diagonal matrix γ(D) = Λ is

∞
X
γ(exp{iωj }) = γ0 + 2 γτ cos(ωj τ ). (23)
τ =1

This represents the cosine Fourier transform of the sequence of the ordinary
autocovariances; and it corresponds to an ordinate (scaled by 2π) sampled at
the point ωj from the spectral density function of the linear (i.e. non-circular)
stationary stochastic process. (An account of the algebra of circulant matrices
has been provided by Pollock 2002. See, also, Gray 2002.)
The circulant autocovariance matrices that are the counterparts of the
ordinary autocovariance matrices defined in (5) are

Ω◦ξ = Ū Λξ U, Ω◦η = Ū Λη U,
(24)
Ω◦ = Ū ΛU = Ū (Λξ + Λη )U,

where Λη and Λξ are diagonal matrices of spectral ordinates. Any of these

autocovariance matrices may be singular in consequence of the presence of zero
elements on the diagonals. Using the circulant matrices instead of the ordinary
autocovariance matrices in the Wiener–Kolmogorov formulae of (8) and (9)
gives

x = Ū Λξ {Λξ + Λη }+ U y = Ū Jξ U y, (25)
h = Ū Λη {Λξ + Λη }+ U y = Ū Jη U y. (26)

To accommodate the possibility that Λξ + Λη is singular, a generalised in-

verse has been applied to it instead of an ordinary inverse. A generalised inverse
can obtained by replacing the zero-value diagonal elements, which correspond
to spectral ordinates falling within dead spaces, by nonzero values and, there-
after, by inverting the matrix that has acquired the full rank. Observe that,
if Λξ and Λη are disjoint such that Λξ Λη = 0, then Jξ = Λξ {Λξ + Λη }+ is a
matrix with units on the diagonal wherever Λξ has nonzero elements and with
zeros elsewhere. Analogous conditions apply to Jη = Λη {Λξ + Λη }+ .
The formulae of (25) and (26) have a simple interpretation. First, the
discrete Fourier transform is applied to the data vector y to translate it into the
frequency domain. Then, a differential weighting, which might entail setting
some values to zero, is applied to the spectral ordinates of the transformed

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 D.S.G. POLLOCK: Econometric Signal Extraction

vector via the diagonal matrices Jξ or Jη . Finally, to produce the estimate of

the component, the inverse Fourier transform is applied.
Implicit in the use of the discrete Fourier transform is the assumption
that the data sequence represents a single cycle of a periodic function. In the
periodic extension of the data, the values from the interval [0, T ) are reproduced
in successive segments of length T that precede and follow the data.
In one sense, there is no start-up problem affecting a Fourier-based filtering
procedure, since the periodic extension constitutes a doubly-infinite sequence.
However, there may be radical disjunctions at the points where one replication
of the data ends and another begins.
Such features are liable to be reflected in the periodogram in a way that
can obscure the underlying data structures. Thus, the ordinates of the Fourier
transform may be affected by a slew of values which serve the purpose only of
of synthesising the end-of-sample disjunctions. One recourse is to taper both
ends of the sample so that they arrive the same level. Another recourse is to
join the sample to it mirror-image reflection and to use this combination in
place of the original data.
The problems of an end-of-sample disjunction are particularly acute in the
case of nonstationary data sequences that follow rising or falling trends; and
the trends have to be eliminated before the filters are applied. So far, we have
succeeded in eliminating the trend by fitting a polynomial function to the data.
An alternative recourse, which we shall pursue in the next section, is to make
use of differencing.
Example 2. Consider the task of extracting the seasonal component from the
residuals that have been obtained by fitting a linear function to the logarithmic
consumption data. The periodogram of Figure 3 suggests that the seasonal
sequence should be synthesised from a small number of Fourier ordinates that
are in the vicinity of the seasonal frequency and its harmonic. In addition to
the ordinates at π/2, we may take two ordinates below and one above. Also,
we may take the ordinate at π and the one immediately below.
The seasonal sequence, which is plotted in of Figure 6, is equally a compo-
nent of the sequence of Figure 4, which represents the residuals from the linear
detrending of the logarithmic consumption data, and a component of the se-
quence of Figure 5, which has been derived by applying a highpass Butterworth
filter to remove a further low-frequency component—represented by the thick
line in Figure 4—that is unrelated to the seasons. In terms of the variances,
the seasonal sequence represents 47 percent of the Figure 4 sequence and 94
percent of the Figure 5 sequence.

4. Filtering Nonstationary Sequences

The problems of a trended data sequence may be overcome by differencing.
The matrix that takes the d-th difference of a vector of order T is given by
∇dT = (I − LT )d . (27)
We may partition the matrix so that ∇dT = [Q∗ , Q]0 , where Q0∗ has d rows.
The inverse matrix is partitioned conformably to give ∇−d
T = [S∗ , S]. We may

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 D.S.G. POLLOCK: Econometric Signal Extraction

observe that · ¸
Q0∗
[ S∗ S] = S∗ Q0∗ + SQ0 = IT , (28)
Q0
and that · ¸ · ¸ · ¸
Q0∗ Q0∗ S∗ Q0∗ S I 0
[ S∗ S]= = d . (29)
Q0 Q0 S∗ Q0 S 0 IT −d
When the difference operator is applied to the data vector y, the first d
elements of the product, which are in g∗ , are not true differences and they are
liable to be discarded: · 0¸ · ¸
Q∗ g
∇T y =
d
y= ∗ . (30)
Q0 g
However, if the elements of g∗ are available, then the vector y can be recovered
from g = Q0 y via the equation

y = S∗ g∗ + Sg. (31)

The columns of the matrix S∗ provide a basis for the set of polynomials of
degree d − 1 defined over the integer values t = 0, 1, . . . , T − 1. Therefore,
p = S∗ g∗ is a vector of polynomial ordinates whilst g∗ can be regarded as a
vector of d polynomial parameters.
We may approach the filtering of a trended data sequence in the following
manner. First, we reduce the data to stationarity by differencing it an ap-
propriate number of times. (We rarely need to difference the data more than
twice.) From the differenced data, viewed in an appropriate manner, we may
discern the nature and the frequency ranges of the various data structures that
we wish to isolate.
Next, the components of the differenced data that correspond to these
structures may be extracted, either by a recursive filtering process—using, for
example, a Butterworth filter—or via the Fourier method described in the
preceding section.
Finally, the components of the differenced data may be integrated, with an
appropriate choice of initial conditions, to provide estimates of the components
of the original trended sequence.
An apparent problem with this procedure is that the act of differencing is
liable to attenuate the components of the low-frequency data structure to such
an extent that they become invisible in the periodogram of the differenced data.
The problem is illustrated in Figure 8, which shows the periodogram of g = Q0 y
in the case of the the once-differenced consumption data.
The problem vanishes when we recognise that we can discern the low-
frequency structure via the periodogram of the residual sequence

y − p = y − S∗ (S∗0 S∗ )−1 S∗0 y

(32)
= Q(Q0 Q)−1 Q0 y,

obtained by fitting to the data, by least-squares, a polynomial of degree d − 1.

The identity Q(Q0 Q)−1 Q0 = I − S∗ (S∗0 S∗ )−1 S∗0 follows from the fact that Q

13
 D.S.G. POLLOCK: Econometric Signal Extraction

and S∗ are complementary matrices with Rank[Q, S∗ ] = T and Q0 S∗ = 0. It

will be recognised that the residuals contain the same information as does the
differenced data Q0 y. Their periodogram, in the case of the consumption data,
has been displayed already in Figure 3.
To elucidate the procedures for extracting the components of a trended
data sequence, let us consider the case of the data vector y = ξ + η, where η,
which has E(η) = 0 and D(η) = Ωη , is from a stationary stochastic process and
where ξ is from a process that requires a d-fold differencing in order to reduce
it to a vector ζ = Q0 ξ with a stationary distribution. Then we shall have

Q0 y = Q0 ξ + Q0 η,
(33)
= ζ + κ = g,

and we may assume, by analogy with (5), that ζ and κ are characterised by
their first and second moments, which are

E(ζ) = 0, D(ζ) = Ωζ = Q0 Ωξ Q,
E(κ) = 0, D(κ) = Ωκ = Q0 Ωη Q, (34)
and C(ζ, κ) = 0.

Here, the derived dispersion matrices Ωζ and Ωκ retain the Toeplitz structure
that is a feature of Ωξ and Ωη .
Let the estimates of ζ and κ be denoted by z and k. If x and h are the
estimates of ξ and η respectively, then it is reasonable to require that Q0 x = z
and Q0 h = k so that
Q0 y = Q0 x + Q0 h
(35)
= z + k = g.
The estimates z and k must be integrated to give

x = S∗ z∗ + Sz and h = S∗ k∗ + Sk. (36)

The criterion for finding the starting value z∗ is

Minimise (y − x)0 Ω−1 0 −1

η (y − x) = (y − S∗ z∗ − Sz) Ωη (y − S∗ z∗ − Sz). (37)

This requires that the estimated trend x should adhere as closely as possible
to the data. The minimising value is

z∗ = (S∗0 Ω−1
η S∗ )
−1 0 −1
S∗ Ωη (y − Sz) (38)

Since y − x = h, an equivalent criterion is

Minimise h0 Ω−1 0 −1
η h = (S∗ k∗ + Sz) Ωη (S∗ k∗ + Sk). (39)

for which the minimising value is

k∗ = −(S∗0 Ω−1
η S∗ )
−1 0 −1
S∗ Ωη Sk. (40)

14
 D.S.G. POLLOCK: Econometric Signal Extraction

Using
P∗ = S∗ (S∗0 Ω−1
η S∗ )
−1 0 −1
S ∗ Ωη , (41)
we get, from (36), the following values:
x = P∗ y + (I − P∗ )Sz, and h = (I − P∗ )Sk. (42)
The disadvantage in using these formulae directly is that the inverse matrix
Ω−1
η , which is of order T , is liable to have nonzero elements in every location.
(This will be so whenever Ωη has the form of an autocovariance matrix of a
moving-average process, as it does in the case of the Butterworth filter, for
example.)
The appropriate recourse is to use the identity
I − P∗ = I − S∗ (S∗0 Ω−1
η S∗ )
−1 0 −1
S ∗ Ωη
(43)
= Ωη Q(Q0 Ωη Q)−1 Q0
to provide an alternative expression for the projection matrix I − P∗ that incor-
porates the band-limited matrix Ωη instead of its inverse. The equality follows
from the fact that, if Rank[R, S∗ ] = T and if S∗0 Ω−1
η R = 0, then

I − S∗ (S∗0 Ω−1
η S∗ )
−1 0 −1
S∗ Ωη = R(R0 Ω−1
η R)
−1 0 −1
R Ωη . (44)
Setting R = Ωη Q gives the result. Given x = y − h, it follows that we can write

x = y − (I − P∗ )Sk
(45)
= y − Ωη Q(Q0 Ωη Q)−1 k,
where the second equality depends upon Q0 S = I.
So far, we have not specified the precise method by which the estimates z
and k of the differenced components have been obtained. They may be obtained
equally via a recursive filtering method or via the Fourier that has been outlined
in the preceding section. In case we have used the Fourier method, we might
be inclined to use the circulant version of the dispersion matrix Ωη within the
foregoing formulae.
Let us consider, instead, the possibility of obtaining the estimate k via
recursive filtering. Then, with reference to equation (9), we can see that the
assumptions of (34) imply that the estimate should take the form of
k = Q0 Ωη Q(Ωζ + Q0 Ωη Q)−1 Q0 y, (46)
On substituting this in the equation of (45), we get
x = y − Ωη Q(Ωζ + Q0 Ωη Q)−1 Q0 y. (47)
In the case of Butterworth filter, we take the quasi-autocorrelation func-
tions of the nonstationary signal sequence ξ(t) and of the stationary noise se-
quence η(t) to be
(1 + z)n (1 + z −1 )n
γξ (z) = σξ2 and γη (z) = ση2 (1 − z)n−d (1 − z −1 )n−d (48)
(1 − z)d (1 − z −1 )d

15
 D.S.G. POLLOCK: Econometric Signal Extraction

11.5

11

10.5

10
1960 1970 1980 1990
Figure 7. The quarterly series of the logarithms of income (upper) and consumption
(lower) in the U.K for the years 1955 to 1994 together with their interpolated trends.

0.3

0.2

0.1

0
0 π/4 π/2 3π/4 π

Figure 8. The periodogram of the first differences of the logarithmic consumption

data.

0.04
0.02
0
−0.02
−0.04
−0.06

0 50 100 150

Figure 9. The bandpass estimates of the fluctuations, within the range of the
business-cycle frequencies, of the logarithmic income series (solid line) and of the
logarithmic consumption series (broken line).

16
 D.S.G. POLLOCK: Econometric Signal Extraction

respectively, which become the elements of (13) in the case where d = 0. We

may also define

γζ (z) = σξ2 (1 + z)n (1 + z −1 )n and γκ (z) = (1 − z)d γη (z)(1 − z −1 )d

= ση2 (1 − z)n (1 − z −1 )n ,
(49)
which is a matter of renaming the elements of (13) when d > 0. The matrices
Ωζ and Ωκ = Q0 Ωη Q are generated by setting z = LT −d and z −1 = L0T −d =
FT −d in γζ (z) and γκ (z) respectively and by scaling the resulting matrices by
the appropriate variances. Observe that the generating functions of (49) are
not affected by the order d of the differencing operator. Therefore, for the
Butterworth filter, only the dimension of the matrix Ωζ + Q0 Ωη Q changes when
d varies. Its essential structure remains the same.
The computational procedure that has been described in section 2 can
also be applied when d > 0. That is to say, the solution of the equation
(Ωζ + Q0 Ωη Q)b = g, where g = Q0 y, is found via the Cholesky factorisation of
Ωζ + Q0 Ωη Q = GG0 . Thereafter, h = Ωη b and x = y − h are found.

Example 3. Figure 7 shows the quarterly sequences of the logarithms of

income (upper) and consumption (lower) in the U.K. for the years 1955 to
1994 together with their interpolated trends. We can afford to treat the income
sequence in the same manner as we treat the consumption sequence; and, in
what follows, we shall concentrate on the latter.
The periodogram of Figure 3, suggests that both the trend component and
the seasonal component of the consumption data are generated by band-limited
processes. The trend component is confined to the frequency interval [0, π/8]
and the seasonal component comprises a handful of nonzero Fourier ordinates
in the vicinities of π/2 and π. The remainder of the periodogram consists
of virtual dead spaces. When equation (4) is applied to these circumstances,
ξ, which is estimated by x, becomes the trend component and η, which is
estimated by h, becomes the seasonal component.
The trend that interpolates the consumption data has been constructed
by extracting from the untrended, twice-differenced data sequence g = Q0 y the
Fourier elements that lie in the frequency interval [0, π/8]. The sequence z
that is synthesised from these elements has then been integrated to create the
trend x = S∗ z∗ + Sz. In seeking the starting value z∗ with which to initiate
the process of integration, we may consider minimising a criterion function
in the form of h0 (Ω◦η )+ h = h0 Ū Λ+ ◦ +
η U h, where (Ωη ) = Ū Λ+
η U represents the
generalised inverse of the singular circulant autocovariance matrix D◦ (η) = Ω◦η .
The elements of Λ+ η that correspond to zero-valued elements of U h, which
lie in spectral dead spaces, can take arbitrary values. These values will have
no effect upon the value of the criterion function. Therefore, the generalised
inverse can be formed by replacing the nonzero elements of Λη by their inverses
and by placing arbitrary values elsewhere on the diagonal.
For want of a better assumption, we may assume that the Fourier ordinates
of the seasonal process are distributed uniformly within their designated bands.

17
 D.S.G. POLLOCK: Econometric Signal Extraction

In that case, the corresponding elements of Λη should all have same value, and
so, likewise, should the corresponding elements of Λ+ η.
The remaining elements of Λ+ η , which correspond to zero-valued Fourier
ordinates and which can take arbitrary values, may be set to the same values
as the elements corresponding to the seasonal ordinates. Thus Λ+ η , which needs
to be determined only up to a scalar factor, becomes an arbitrary multiple of
the identity matrix—and it may as well become the identity matrix itself. In
that case, we should have Ω◦η = Ū U = I and (Ω◦η )+ = I.
This simplification allows us to specialise equation (38) to give

z∗ = (S∗0 S∗ )−1 S∗0 (y − Sz). (50)

In the case where the data is differenced twice, there is

· ¸
0 1 2 ... T − 1 T
S∗ = (51)
0 1 ... T − 2 T − 1

The elements of the matrix S∗0 S∗ can be found via the formulae

X
T
1
t2 = T (T + 1)(2T + 1) and
t=1
6
(52)
X
T
1 1
t(t − 1) = T (T + 1)(2T + 1) − T (T + 1).
t=1
6 2

(A compendium of such results has been provided by Jolly 1961, and proofs
of the present results were given by Hall and Knight 1899.) The matrix is
somewhat ill-conditioned. Moreover, when the order of differencing exceeds two
or three, it is necessary, in calculating the polynomial ordinates of p = S∗ z∗ , to
use to an orthogonal basis in place of the monomial basis that is provided by
the columns of S∗ . However, this case is rare.

5. Bandpass Filtering
Econometricians often characterise the business cycle in terms of a sinusoid
that fluctuates around a slow-moving trend. According to the definitions of
Burns and Mitchell (1946), the effects of the business cycle within an economic
index correspond to the sinusoidal elements therein that have periods of no less
than one-and-a-half years and of no more than eight years. A duration of one-
and-a-half years seems too short, and we prefer to set the shortest duration at 2
years—and this seems to be a common preference (see, for example, Christiano
and Fitzgerald 1998).
The business cycle, defined in this manner, is unlikely to correspond to any
self-contained spectral structure that might be discerned by inspecting the rele-
vant periodogram. In the case of quarterly data, the business cycle frequencies
range from π/16 radians per period to π/4 radians per period (corresponding
to a duration of 2 years.) Neither of these values corresponds to a natural break
in the periodogram of the consumption residuals of Figure 3.

18
 D.S.G. POLLOCK: Econometric Signal Extraction

Im Im
i i

Re Re
−1 1 −1 1

−i −i

Figure 10. The pole–zero diagrams (left) of the lowpass Butterworth filter of order
n = 12 with a cut-off frequency of ωU = π/4 and (right) of the highpass filter of
order n = 6 with a cut-off frequency of ωL = π/16.

1.25
1
0.75
0.5
0.25
0
0 π/4 π/2 3π/4 π
Figure 11. The gain of the 12th order digital Butterworth lowpass filter with cut-off
frequency of ωU = π/4 and of 6th order highpass filter with cut-off frequency of
ωL = π/16, superimposed on the same diagram.

The business-cycle frequencies may be extracted from the data using a

bandpass filter with nominal cut-off points at the designated frequencies. For
this purpose, economists have tended to use finite-impulse-response (FIR) or
moving-average filters that are derived by truncating the doubly-infinite se-
quence of filter coefficients associated with the unrealisable ideal bandpass fil-
ter. (See, for example, Baxter and King, 1999.) The effect of the truncation
is to create ripples in the stopbands of the frequency response function, which
entail considerable spectral leakage.
A superior bandpass filter can be realised using the Butterworth formu-
lation. One way of creating a bandpass filter is to apply the so-called Con-
stantinides (1970) transformation to a prototype lowpass filter with a nominal
cut-off point at π/2. The method is also described by Pollock (1999). In the
current application of business cycle analysis, this transformation will result in
a filter with a frequency response that has a far wider transition band at the
upper cut-off frequency than at the lower cut-off frequency.

19
 D.S.G. POLLOCK: Econometric Signal Extraction

A better way of creating a bandpass filter for the current application is

to apply two filters in succession. The first filter is a lowpass filter that is
intended to remove the components of frequencies in excess of π/4. The second
is a highpass filter that preserves the remaining components of frequencies in
excess of π/16 and eliminates those of lesser frequencies. The order of the
first filter should exceed that of the second filter so as to enhance the rate of
transition at the upper cut-off frequency.
Figure 10 shows the pole–zero diagrams of the 12th order lowpass and
the 6th order highpass filters; while Figure 11 shows the frequency response
functions of the two filters superimposed on the same diagram. It can be seen
that some of the poles of the highpass filter come very close to the circumference
of the unit circle. This feature can lead to problems of numerical instability.
One way of overcoming the problems of numerical instability is to sub-
sample the data that has resulted from applying the first filter. Since there
is no information in this data remaining in the interval [π/2, π], we can afford
to omit alternate points so as to create a semi-annual sequence. The effect is
that the contents of the original data that lie in the frequency interval [0, π/2]
are mapped into the wider interval [0, π]. In the process, the lower cut-off
frequency moves from π/16 to π/8. The poles of the 6th-order Butterworth
filter with this cut-off point are no longer so close to the perimeter of the unit
circle, which implies a greater numerical stability. (More general methods of
sample-rate conversion have been described by Vaidyanathan 1993, amongst
others.)
An alternative recourse is to base the estimate of the business cycle compo-
nent on the Fourier ordinates of the data that fall within the specified frequency
range. In principal, the method entails no spectral leakage so long as it is ap-
plied to data that have been detrended in a manner that will ensure that there
are no disjunctions in the periodic extension where the end of one data segment
joins the beginning of another. This can be achieved by a process of differencing
followed by a judicious tapering of the ends of the data segment.
Since the business cycle is an artificial construct, it is difficult to relate
the method of extraction to an underlying statistical model. However, under
certain assumptions, it becomes appropriate to treat this component in the
same manner as the noise component η within the trended vector y = ξ + η,
which has been the subject of the previous section.
Now the component vector ξ becomes the repository of the Fourier ele-
ments with frequencies that are less than the value of the lower cut-off fre-
quency of the pass band. The components of frequencies in excess of the upper
cut-off frequency can be assigned to a third component, which is eliminated via
the first lowpass filtering operation. The vector y can be taken to represent the
product of this operation.
Under these constructions, there are no spectral overlaps amongst the var-
ious components; and the appropriate statistical model is one that comprises
separable band-limited processes. It follows that the appropriate method for
extracting the business-cycle component is, indeed, the Fourier-based method
of Section 3. This is well-adapted to dealing with band-limited processes. The

20
 D.S.G. POLLOCK: Econometric Signal Extraction

relevant Fourier components of the business cycle, contained in the vector k,

must be extracted from a data vector g = z + k that has been detrended by
differencing. The estimate
h = S∗ k∗ + Sk (53)
of the business cycle component is obtained by a process of summation that
reverses the differencing.
In the absence of prior knowledge of the distribution of the spectral ordi-
nates, we may set Ωη = I. In that case, the starting values are provided by the
simplified formula
k∗ = (S∗0 S∗ )−1 S∗0 Sk. (54)
which is derived from equation (40) by setting Ω−1
η = I. The simplification
extends to the identity of (43), which becomes

P∗ = S∗ (S∗0 S∗ )−1 S∗0

(55)
= I − Q(Q0 Q)−1 Q0 = I − PQ .

Therefore, the estimate of the business cycle component is also provided by

h = (I − P∗ )Sk = Q(Q0 Q)−1 k, (56)

wherein the condition Q0 S = I has been effective in simplifying the final ex-
pression.
Example 4. Figure 9 shows the business cycle fluctuations that have been
extracted from the quarterly logarithmic income and consumption data for the
U.K. over the period 1955 to 1994. In both cases, a Fourier bandpass filter
has been applied that has a lower cut-off point at π/16 radians per period
(corresponding to a cycle of 8 years duration) and an upper cut-off point of
π/4 radians per period (corresponding to a cycle of 2 years duration).
There is evidence here that the fluctuations in consumption precede those
in income. This contradicts the common supposition that the business cycle
is driven by variations in ‘‘autonomous expenditures”, which do not include
consumption, and in the rate of investment.
One might be doubtful of the comparisons at the beginning and the end of
the sample, where the interpolated functions are not tied down by precedeing
or succeeding data points and where they appear to be heading in opposite
directions. The problem could be overcome by adding a few extrapolated points
at either end of the sample that would serve to tie down the functions.

6. Multiple Components
The problems of econometric signal extraction have been handled, so far, within
the context of a model, described by equation (4), that has only a signal com-
ponent and a noise component. Allowance has been made for a non stationary
signal component. However, it might be required to partition the data amongst
more than two components. Thus, in a classical econometric time-series anal-
ysis, at least four components are identified. These are the trend, the business
cycle, the seasonal cycle and an irregular component.

21
 D.S.G. POLLOCK: Econometric Signal Extraction

The two-component model can also serve the purpose of extracting several
components, for the reason that its components are readily amenable, if neces-
sary, to further decompositions. Thus, for example, an initial decomposition of
the data sequence into a trend/cycle component and a residue can be followed
by decomposition of the residue into a seasonal cycle an irregular cycle. If the
data are stationary, it is unnecessary to perform such a multiple decomposition
sequentially—each component can be extracted separately.
If the data are nonstationary and if there are more than one nonstationary
component, then a sequential decomposition might be called for. A typical
model of an econometric time series, described by the equation y = ξ + η =
(µ + ρ) + η, comprises both a trend/cycle component µ and a seasonal compo-
nent ρ that are described by ARIMA models with real and complex unit roots
respectively.
To reduce the data to stationarity, an operator is used that is the product
of the d-fold difference operator ∇dT = (I −LT )d and a deseasonalising operator
ΣT = (I − LsT )(I − LT )−1 . (The operator Σ is used instead of (I − LsT ) because
it can be assumed, without loss of generality, that the seasonal deviations from
the trend have zero mean.) Let the product of the two operators be denoted
by MT = ΣT ∇dT = [Q∗ , Q]0 , where Q0∗ contains the first d + s − 1 rows of the
matrix, and let the inverse operator MT−1 = [S∗ , S] be partitioned conformably
such that S∗ contains the first d + s − 1 columns. The factors of MT−1 are
further partitioned as Σ−1 −d
T = [SΣ∗ , SΣ ] and ∇T = [S∇∗ , S∇ ].
Let the components of the differenced data be denoted by Q0 ξ = ζ, Q0 µ =
ζµ and Q0 ρ = ζρ . Then there is

Q0 y = Q0 ξ + Q0 η
(57)
= Q0 (µ + ρ) + κ = (ζµ + ζρ ) + κ.

Also, let the estimates of µ and ρ be denoted by m and r and those of ζµ and
ζρ by zm and zr . Then, in parallel with equation (57), there is

Q0 y = Q0 x + Q0 h
(58)
= Q0 (m + r) + k = (zm + zr ) + k.

The estimates zm , zr and k may be obtained from the differenced data g = Q0 y

by a process of linear filtering. It is then required to form m, r and h from
these elements. First, consider

x = (m + r) = S∗ z∗ + Sz
(59)
= S∗ z∗ + S(zm + zr ).

Here, z∗ is computed according the formula of (38). Given x, an estimate

h = y − x of the irregular component can be formed. Next, there is an equation
· ¸
z∗m
S∗ z∗ = [ S∇∗ SΣ∗ ] . (60)
z∗r

22
 D.S.G. POLLOCK: Econometric Signal Extraction

This may be solved uniquely for z∗m and z∗r ; and, for this purpose, only the
first s + d − 1 rows of the system are required. Thereafter, the estimates of µ
and ρ are given by

m = S∇∗ z∗m + Szm and r = SΣ∗ z∗r + Szr . (61)

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