Forecasting and Smoothing using

the Kalman Filter

Presenter
Central Bank of Algeria Kaddour Hadri
Macroeconomic Forecasting
L11, March 2, 2017
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 Roadmap
I. Introduction
II. The state space representation
III. The Kalman filter
IV. ML estimation and the Kalman filter
V. Forecasting and smoothing
VI. Concluding remarks

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 I. Introduction
• The dynamics of time series could be influenced
by the dynamics of a set of variables i.e. states.
• State space models describe the law of motion of
the states and their link with observations. The
Kalman filter is an algorithm to estimate it.
• Classical regression analysis would fail in terms of
validity of tests (t-test F-test…) and in terms of
forecasts if these states were unobservable and
persistent.
• State space representation encompasses the
standard models (e.g. ARMA).
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II. State Space Representation

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 Diagram of a state space form
t-1 t time

Yt-1 Measurement Yt
equation Observed

Hidden

αt-1 αt
Transition State
equation variable
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The state space representation 1/2
• A time series y is observed
• Suppose that y is explained by a set of
unobserved variables or state variables subject
to a measurement equation:
yt = Zt αt +εt , εt ~NID(0, Ht)

• The state variables’ dynamics is given by the

state/transition equation:
α t+1 = Tt αt + Rt ηt , ηt ~NID(0, Qt)

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The state space representation 2/2
• It is also assumed that:

E(εt ηs)=0, E(α0 εt)=0 and E(α0 ηt)=0

• The model can also include exogenous

variables both in the measurement and
transition equations.

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 Hyper-Parameters
• In the state space model the parameters Ht Qt
Rt Tt Zt are referred to as “hyper-parameters”
and are unknown in general.
• The main task of the Kalman filter will be to
estimate these parameters.
• Contrary to standard regressions, there are no
analytical solutions and the estimation
requires an iterative procedure (maximum
likelihood).

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 Why a recursive algorithm is the
natural approach to state space forms?
• In a state space form the notion of forecasting
given different information sets appears naturally
(e.g. dynamic vs. one-step-ahead).
• Given information on the initial state (time t), it is
possible to construct a forecast of the state (time
t+1).
• Given the observation (time t+1), it is possible to
refine the estimate of the state (time t+1).
• Given initial conditions, the recursion could be
used for the estimation.
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III. The Kalman filter

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 Filtering, predicting and smoothing?
• All these refer to the same concept i.e.
estimating the state vector.
• The difference between them is the set of
information used in the estimate:
 Filtering is based on past observations and current
observations.
 Predicting is based on past observations only.
 Smoothing is based on all past and future
observations.

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 The Kalman filter
• The Kalman filter is a recursive procedure to
estimate the state vector of a state space form
given all past and current observations.
• Given an initial state vector (normality) and
hyper-parameters or transition matrices, the
Kalman filter computes recursively the
conditional distributions of the state vector.
• It has applications in engineering e.g. satellite
location.

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 Properties of the Kalman filter
• Under normality condition (initial state and
disturbances), the Kalman filter produces an
optimal estimator of the state vector
(minimum Mean Square Error).
• If normality is dropped the Kalman filter still
produces the optimal estimator in the class of
linear predictors.

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 Algorithm: schematic diagram
t t+1 time

Kalman Predicted yt+1 is observed

filtered state:
state: at at+1|t=Ttat Forecast error:
vt = yt+1 - yt+1|t
Predicted
observation: Kalman gain: Kt
yt+1|t=Ztat+1|t
Kalman filtered
state:
at+1=at+1|t+Ktvt
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 Initialization
• The starting value of the Kalman filter may be
specified in terms of a0 and P0

• Diffuse initialization means that the initial

values are estimated

• They can be measured from outside

information.
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 Period t: initial values
• Let at denote the optimal estimator of αt the
state vector at time t given all past
information including yt i.e. the Kalman
filtered state.

• Let Pt denote var-cov of the estimation error:

Pt=E[(αt- at) (αt- at)’]

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 Period t: prediction equations
• Given at and Pt the optimal estimator of αt+1

at+1|t=Ttat

• Associated with an estimation error var-cov

matrix
Pt+1|t=TtPtT’t+RtQtR’t

• The predictor of next period’s observation

yt+1|t=Ztat+1|t
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 Period t+1: Forecasting error
• Observing yt+1 yields the forecast error:
vt = yt+1 - yt+1|t

• Associated with the var-covar matrix:

Ft =ZtPt+1|tZ’t+Ht

• Define the Kalman gain:

Kt =Pt+1|tZ’t Ft-1
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 Period t+1: Updating equations
• Given the forecast error, the Kalman filtered
state at time t+1 is an update of at+1|t:
at+1=at+1|t+Ktvt

• Associated with the var-covar matrix:

Pt+1 =Pt+1|t-KtZtPt+1|t

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 The Kalman gain and updating
• The Kalman gain measures the uncertainty of
the state based on past observations relative
to the uncertainty of the new observation.
• It determines the influence of the prediction
error of yt+1|t on the estimate of the state at
time t+1.
• In time-invariant models the Kalman gain
converges to a constant simplifying the
calculation of steady-state Kalman filter.

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IV. ML estimation

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 Estimation
• The Kalman filter is applied given the hyper-
parameters. But how do we estimate those?

• The Kalman filter plays a crucial role in their

estimation too! Why?

• The reason stems from the way the Likelihood

function is calculated.
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 Maximum likelihood
• The theory of ML: given a set of observations
y=y1 ,…, yT (iid):
L(y,Ψ)=p(y1)…p(yT)
• In the state space model the observations are
not iid, thus instead:
L(y,Ψ)=Πp(yt|yt-1,yt-2,…,y1)
• Under normality conditions (initial state and
disturbances) yt|yt-1,yt-2,…,y1~N
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 ML and the Kalman filter
• The Kalman filter computes the mean and covariance
of yt|yt-1,yt-2,…,y1
• The mean is Ztat and the variance is Ft
• Numerical techniques yield the ML estimator of hyper-
parameters Ψ
• In the univariate model the log lieklihood is:
-T/2log(2π)-1/2(logF1+ v12 /F1+…+logFT+ vT2 /FT)
• The maximization is such that the weight on past
observations minimizes the prediction error of current
observation (unlike classical regressions where past
and future have the same weight).

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V. Forecasting and smoothing

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 Forecasting
• A state space form is estimated (suppose time
invariant).
• Suppose the last observation occurs at T+1.
• The filtered state at time T+1 is updated:
aT+1=aT+1|T+KTvT
• The forecast for T+n is simply:
yT+n|T=Z(T)n-1 aT+1

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 Smoothing
• Recursive algorithms “state and disturbance
smoothers” are applied to the output of the
Kalman filter.
• The goal is to obtain an estimate of the state
vector taking into account all observations
(past and future).
• Could be applied to estimate potential GDP
for example.

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 VI. Concluding remarks
• The state space model/Kalman filter is a
powerful and flexible tool. It can be applied to
non-stationary time series.
• It handles difficult issues like time varying
coefficients and missing data relatively easily.
• The normality condition is important to
ensure optimality and there are methods to
verify it.

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