Economic Policy Uncertainty

Publication Date :

26 Dec, 2024

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Table Of Contents

What Is Economic Policy Uncertainty?

Economic Policy Uncertainty (EPU) refers to an index created from newspaper reports concerning policy uncertainty taken from leading newspapers containing key terms like uncertain or uncertainty, economy or economic, and other policy terms. It acts as an indicator for decision-makers in planning strategies and navigating economic situations during policy volatility.

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The EPU index grows exponentially during major political events such as financial crises, elections, and wars. These events impact fields such as finance, healthcare, and defense, causing volatility in stock prices and decreasing employment and investment. Globally, EPU relates to economic downturns and affects investment and outcomes throughout more significant economies.

Key Takeaways

Economic policy uncertainty characterizes an index that was developed using newspaper articles on policy uncertainty extracted from reputable publications. The articles included important terms like "economic, economy or uncertain" and "uncertainty."
It serves as an indicator for those in charge of making decisions, navigating volatile policy environments, and formulating plans.
It can be measured using media coverage involving data from prominent newspapers, tax code expirations, and forecaster disagreement.
It has negative impacts on investment, decision-making, efficiency, risk perception, and economic recovery, leading to decreased business investment, increased risk perception, and delayed investment.

Economic Policy Uncertainty Explained

Economic policy uncertainty is the degree of unpredictability about economic decision-making steered by state policies quantified by monitoring the frequency of specific terms in newspaper articles. Scott R. Baker, Nicholas Bloom, and Steven J. Davis developed it in 2014 based on the potential impacts of economic uncertainty and policy decisions. It acts as a metric of ambiguity around government policies, representing concerns regarding the future direction, consistency, and clarity of economic policy decisions.

The index gauges the degree of uncertainty throughout various sectors that are reactive to changes in policy, such as defense. Any increase in EPU leads to barriers in corporate investment, increases financial market volatility, and decreases consumer spending. Moreover, different sectors lead their firms to use highly conservative financial approaches during unpredictable times.

The EPU index has become a vital tool for financial analysts and policymakers. They track economic policy uncertainty data levels to gauge economic sentiment and modify strategies accordingly. Furthermore, businesses utilize information obtained from measuring economic policy uncertainty to make wise and informed decisions regarding risk management and capital allocation.

In the financial world, EPU tends to increase stock markets' volatility because of investors' reaction to uncertainty. It may also affect the credit domain, as lenders may put stringent conditions on loans out of fear of borrowers defaulting due to economic instability. Hence, it can be said that EPU does play a critical role in shaping market dynamics.

How To Measure?

There are three elements used in measuring the economic policy uncertainty index, namely media coverage, tax code expirations, & forecaster disagreement with the following elements:

#1 - Media Coverage

First, monthly data has to be collected from prominent newspapers featuring terminology such as policy, uncertain, and economic.
Then, the number of relevant articles has to be compared to the total number of articles, forming a normalized index representing business and public concerns.

#2 - Tax Code Expirations

Here, one has to track the expiration of the scheduled tax code over the coming decade.
Then, one uses data on projected revenue impact to calculate the level of uncertainty, particularly for temporary tax metrics impacting households and businesses.

#3 - Forecaster Disagreement

One has to measure the differences in estimation from expert economists regarding government expenditures and inflation.
If the forecast has greater discrepancies, this means higher uncertainty concerning future economic policy.

However, one must note that these three elements have to be aggregated, with Tax Code Expirations weighted at 25%, Forecaster Disagreement weighted at 25 %, and Media Coverage weighted at 50%.

Examples

Let us use a few examples to understand the topic.

Example #1

An online article published on August 30, 2024, highlights the effects of rising economic policy uncertainty on Q4 US growth. Business investment in nonresidential structures is expected to decline by 4.3 percentage points (ppts), while equipment spending is forecasted to drop by 3.4 ppts due to heightened uncertainty. Personal consumption of durable goods is also at risk, with a potential reduction in Q4 growth by up to 2.8 ppts, though there is skepticism about this decline materializing fully. Major fiscal policies impacting households are not expected until 2026. Residential investment, however, is forecasted to see a slight increase in Q4, driven by improved housing supply and lower mortgage rates, despite recent unfavorable home sales data.

Example #2

Let us assume that the central bank of Old York City, Echelona, has concerns regarding the rising uncertainty in economic policy. Echelona gathers data from various sources, such as recent shifts in trade policy, news reports, and business sentiments. All this collected information aids the central bank in evaluating how proposed tax reforms could affect vital financial indicators such as loan applications and investment levels.

More importantly, these are from the key metrics of financial system efficiency (FSE) of Old York's central bank. Based on these data, Echelona analyses data to forecast whether such reform measures might negatively affect uncertainty and destabilize a country's financial ecosystem. Based on these insights, Echelona advises the policymakers of Old York City regarding going forward with the tax reforms or executing steps to decrease the risk of economic recession.

Effect On Investment

It has a multitude of impacts on investment, as discussed below:

If EPU increases, business investment will decrease because companies will take a cautious approach to their future policies.
Uncertainty in economic policies damages decision-making, transforming enthusiasm into hesitancy.
Local policies of uncertainty aggravate investment decisions, particularly when it comes to frequent policy adaptation.
Businesses reduce or delay investments to bypass risks related to uncertain economic environments.
The high degree of EPU negatively affects the efficiency and scale of investments, adding to over- and under-investment.
Heightened EPU enhances risk perception, lowering investor sentiment and badly reducing business investment.
EPU makes economic recovery sluggish as it creates ambiguity regarding the nature and timing of future policy changes.