A Little-Known Index Measures Economic Uncertainty

by: Mark Shore
Summary

Three factors derive the U.S. EPU index.

The EPU index may be useful as a short-term aggregate sentiment indicator.

The index tends to imply an environment of varying levels of perceived uncertainty more so than forecasting recessions.

Over the years, I’ve heard the adage “we live in uncertain times,” but can we quantify that statement? Can one point to evidence of living in uncertain times? Does uncertainty vary over time and between topics? The term uncertainty commonly defined as unknown expected outcomes and unknown probabilities.[1]

A few academics (Baker, Bloom, and Davis, 2013)[2] tried to solve this question and quantify economic uncertainty with the development of the Economic Policy Uncertainty Index (EPU). This little known index, EPU is attaining increased use among academics, practitioners, and government.[3] The data is available on the website of the Federal Reserve Bank of St. Louis (FRED) among other locations. The U.S. EPU index data began in January 1985. The index developer’s National Bureau of Economic Research (NBER) paper demonstrates how the EPU performed back to 1900 (Baker, Bloom and Davis, 2015).[4] As they note in their paper “At the macro level, policy uncertainty innovations foreshadow declines in investment, output, and employment in the United States.”

Methodology

Three factors derive the U.S. EPU index: 1) Monthly textual analysis from 10 large newspapers searching for articles with economic and policy-related terms. 2) Tax code expiration data from the Congressional Budget Office (CBO). Indeterminate if tax codes will expire or not is possible uncertainty for businesses and individuals. 3) Wider dispersion of economic forecasts from the Federal Reserve Bank of Philadelphia’s survey of professional forecasters. The disagreement of estimates would imply a higher probability of uncertainty.[5] Over the years, they have created the index into a franchise of indices for 23 countries, Europe and a global index. Except for the U.S. index, several EPU benchmarks calculate their results from only monthly textual analysis of local newspapers. Several other uncertainty related indices developed from the initial index.

Testing the quality of the EPU results, it was compared to the frequency of “uncertainty” and policy related “uncertainty” type terms in the Fed’s Beige book from Q4 1983 to Q4 2012 and found similar results to the EPU index with a 0.8 correlation. Their hypothesis “higher uncertainty leads to a greater frequency of large equity market moves and, in particular, higher policy uncertainty leads to a greater frequency of jumps triggered by policy-related developments.”[6]

Index changes are often related to specific events or discussions of policies such as the 1987 crash, Russian Crisis/ LTCM, close political elections, the financial crisis, European debt crisis, the 9/11 attack and several other shocks to the economic system.[7]&[8]

Application

The EPU index may be useful as a short-term aggregate sentiment indicator. For example, I recently discussed the European uncertainty index concerning trade tensions and volatility in Europe. Since the financial crisis, the index has drifted higher. It peaked around the Brexit vote and then reached a bottom when trade tensions between the U.S. and China increased in 2018.

Fig 1: US Economic Policy Uncertainty Index (using three factors) Jan 1985 to March 2019

Source: Federal Reserve Bank of St. Louis

Figure 1 notes the behavior of the U.S. index since 1985 and how the index tends to rally before the official start of a recession. Also, moments of the index peak as the recession officially reaches an end. Therefore, as a recession ends, individuals and organizations feel wealthier, the confidence of consumers/ investors may strengthen, and uncertainty wanes. This feeling of increased wealth is known as the wealth effect in behavioral science.[9] The EPU index may also rally without the occurrence of a recession. Therefore, the index tends to imply an environment of varying levels of perceived uncertainty more so than forecasting recessions.

Figure 2: Monthly EPU of Europe, China & the U.S. (The U.S. Index based on the first factor). Jan 1985 to April 2019.

Source: 'Measuring Economic Policy Uncertainty' by Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com

Figure 2 illustrates the monthly EPU index of the U.S., Europe, and China from their respective inception dates. In this chart the U.S. EPU index is derived from only the textual analysis factor, to make it comparable to the other indices. Since the financial crisis, overall uncertainty has trended higher as illustrated in the dashed lines. The China EPU index has spiked a few times since 2015. January 2018 the index bottomed at 122 and then peaked in December 2018 at 935. The recent bottom and top may be related to trade tensions.

Conclusion

In future articles, I’ll discuss more of these indices, but this is an appropriate time to introduce the EPU index and its potential application. The next time someone talks about uncertainty, you can turn to a benchmark and determine if we are living in uncertain times and if it impacts your decision-making and your investments.


[1] Shore, M. (2008). Introduction of Risk Management. Octane Research Newsletter

[2] Baker, S., Bloom, N., & Davis, S. (2013, May). Measuring Economic Policy Uncertainty Retrieved from http://faculty.chicagobooth.edu/steven.davis/pdf/BakerBloomDavis.pdf

[3] Economic Policy Uncertainty Index

[4] Baker, S., Bloom, N., & Davis, S. (2015, October). Measuring Economic Policy Uncertainty Retrieved from NATIONAL BUREAU OF ….Retrieved from http://www.policyuncertainty.com/media/BakerBloomDavis.pdf

[5] Economic Policy Uncertainty Index

[6] Baker, S., Bloom, N., & Davis, S. (2013, May). Measuring Economic Policy Uncertainty Retrieved from http://faculty.chicagobooth.edu/steven.davis/pdf/BakerBloomDavis.pdf

[7] A Precise Measure of Uncertainty? (2017, September 21). Retrieved from A precise measure of uncertainty? | FRED Blog

[8] Baker, S., Bloom, N., & Davis, S. (2013, May). Measuring Economic Policy Uncertainty Retrieved from http://faculty.chicagobooth.edu/steven.davis/pdf/BakerBloomDavis.pdf

[9] Shore, M. (2000 July). “Trading and Biases don’t mix.”. Futures (Cedar Falls, Iowa) (07462468), 29 (9), p. 44.

Past performance is not necessarily indicative of future results. The opinions expressed are solely those of the author and are only for educational purposes.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.