Measuring Economic Policy Uncertainty: A Study Analysis

Could investors and consumers have benefited from an index marrying policy and economic uncertainty before the 2008 financial crisis? During the crisis, economic policy uncertainty surrounding taxes, spending, regulation, and monetary policy rose to historic levels. Since then, the US has faced some of the greatest economic challenges and policy interventions since the Great Depression. Commentary from leading policymakers, economists, and financial experts suggests economic policy uncertainty remains a significant factor in the slow post-recession recovery of business and household investment, hiring, and consumption.

In a recent study, “Measuring Economic Policy Uncertainty,” authors Scott Baker, Nicholas Bloom, and Steven Davis investigate the effects of such commentary through the construction of an Economic Policy Uncertainty (EPU) index. The EPU index captures three main components of economic policy uncertainty: frequency of news reference to fiscal and monetary policies, upcoming expirations of federal tax code provisions, and the disagreement among economic forecasters over future government purchases and inflation.

In measuring frequency of news reference to economic policies, the authors monitor articles from ten large newspapers. The EPU index develops a monthly count of articles containing keywords such as “uncertainty, economy, congress, deficit, federal reserve, legislation, regulation, and white house,” as well as the derivations or roots of these words such as “economic, regulatory, and fed.” The results are then adjusted to reflect monthly publishing volume differentials.

The second component of the index utilizes information from the Congressional Budget Office to measure scheduled expirations of federal tax code provisions as well as their projected budget revenue effects. Scheduled tax expirations are a source of uncertainty, especially recently, due to Congress’ tendency to wait until the final hour to decide whether to extend them. This undermines stability and certainty for businesses and households on future tax plans. Using a discount rate of 50 percent per year, the index tracks the present value of expiring tax provisions over a ten-year time frame.

The third component of the EPU index derives its information from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters (SFP). Using quarterly survey data from the SFP, the index measures two variables. The first variable measures the dispersion of forecasts on consumer price inflation, and the second variable measures federal and state purchases, expressed as a percentage of state and federal gross domestic product.

Aggregating these three components together, the EPU index is then benchmarked against other measures of uncertainty. Specifically, when measuring the EPU against the Chicago Board Options Exchange Market Volatility Index (VIX), the authors observe a somewhat strong correlation. The VIX measures the 30-day implied volatility of the S&P 500 index. The VIX rises far more significantly than other indices during financial crises, such as the Asian economic crisis of 1997, the Russian debt crisis of 1998, the 2002 financial scandals at WorldCom and Enron, and the 2008 Leman Brothers collapse. Each of these events holds a strong connection to stock markets. The EPU index, by contrast, spikes tightly during presidential elections, Gulf Wars I and II, and the 9/11 attacks. During and since the 2008 US financial crisis, the EPU index rose to historic highs after the Lehman bankruptcy, TARP legislation, 2010 midterm elections, Eurozone crisis, and US debt-ceiling debate. These events highlighted by the EPU index are more policy related than those highlighted by the VIX, holding both financial and national policy implications.

Economic policy will continue to be debated as Washington gridlock amplifies the uncertainty of spending, taxing, and regulating decisions and the Federal Reserve reconsiders its quantitative easing program and employment and inflation objectives. This uncertainty touches everyone, from investors in stock and bond markets to homeowners seeking mortgage loans. The EPU index offered by the authors of this study provides a foundation and basis on which to measure this uncertainty and it has the potential to guide future policy decisions with more stability and certainty. Reducing this uncertainty will undoubtedly be a benefit to the US economy during its continued recovery.

Feature Photo: cc/(Alex Proimos)