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Measuring Economic Policy Uncertainty Scott R. Baker (Stanford) Nick Bloom (Stanford & NBER) Steve Davis (Chicago Booth & NBER) Hoover Institution, Friday.

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Presentation on theme: "Measuring Economic Policy Uncertainty Scott R. Baker (Stanford) Nick Bloom (Stanford & NBER) Steve Davis (Chicago Booth & NBER) Hoover Institution, Friday."— Presentation transcript:

1 Measuring Economic Policy Uncertainty Scott R. Baker (Stanford) Nick Bloom (Stanford & NBER) Steve Davis (Chicago Booth & NBER) Hoover Institution, Friday December 2 nd 2011

2 The paper tries to investigate the claim that policy uncertainty contributed to the recession of We find three preliminary results: 1.Policy uncertainty fluctuates over time, and since 2008 has reached all-time high levels 2.Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty 3.Policy uncertainty appears to lower economic growth and raise stock-market volatility

3 We find three preliminary results: 1.Policy uncertainty fluctuates over time, and since 2008 has reached all time high levels 2.Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty 3.Policy uncertainty appears to lower economic growth and raise stock-market volatility The paper tries to investigate the claim that policy uncertainty deepened the recession of

4 Figure 1: Our main index of policy uncertainty Policy Uncertainty Index 1 st Gulf War 9/11 Clinton Election 2 nd Gulf War Bush Election Balanced Budget Act Lehman and TARP Euro Crisis, 2010 Midterms Large interest rate cuts, Stimulus Banking Crisis, Obama Election Debt Ceiling; Euro Debt Source: Measuring Economic Policy Uncertainty by Scott Baker, Nicholas Bloom and Steven J. Davis, November 2011, at

5 Our economic policy uncertainty index is built from three sub-components 1.Newspaper coverage of policy-related economic uncertainty 2.Number of federal tax code provisions set to expire 3.Disagreement among economic forecasters over future: a.levels of the CPI b.federal government purchases of goods & services The overall index is constructed from a 50% weight on the broad newspaper index and equal weight on the others (but results are pretty robust to different weighting measures)

6 Sub-component 1): News-based policy uncertainty index Policy Uncertainty News Index 1 st Gulf War 9/11 Clinton Election 2 nd Gulf War Bush Election Interest Rates, Stimulus Lehman and TARP Euro Crisis, 2010 Midterm Russian Crisis/LTCM Debt Ceiling; Euro Debt Obama Election, Banking Crisis Notes: Frequency of the triple of economy/economic, uncertain/uncertainty and one of a collection of policy terms (policy, regulation, federal reserve tax, spending, budget and deficit) in US Google news normalized by the smoothed frequency of the word today. Normalized to 100.

7 Financial Uncertainty Index 1 st Gulf War 9/11 Lehman Bankruptcy 2 nd Gulf War Asian Crisis Russian Crisis/LTCM Black Monday Check of news based indices example: tracking financial uncertainty Notes: Frequency of the triple of economy/economic, uncertain/uncertainty and one of a collection of financial market terms (e.g. stock price, equity price, stock market etc ) in US Google news normalized by the smoothed frequency of the word today. Both series scaled to same mean.

8 War and Terror Uncertainty Index Notes: News-Based War and Terror Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as the term war or terror (scaled by the smoothed number of articles containing today). Google query run June 15, Index covers January 1985-May st Gulf War 2 nd Gulf War 9/11 Bush Election Check of news based indices example: tracking war and terror uncertainty

9 Notes: Utilizes List of Tax Expirations from the Joint Committee on Taxation. Each years forecast is a 10-year horizon of expiring tax laws. Future expirations weighted by 0.5^((T+1)/12) where T is the number of months until the tax expires Tax Legislation Expiration Index Sub-component 2) Tax expiration index

10 Indexes of Scheduled Tax Code Expirations Based on CBO Data, Preliminary Our dollar (rather than equal) weighted tax expiration index shows an even steeper rise

11 Notes: From the Philadelphia Federal Reserve Survey of Professional Forecasters. Takes the interquartile (IQ) range of the 1-year ahead forecasts (made every quarter) of total federal government expenditures relative to the mean forecast. Normalized to a mean 100 index prior to Aug Sub-component 3a): CPI disagreement index CPI Forecasters IQ Range Index 2 nd Gulf War/ Fed Drops Interest Rates 1 st Gulf War Clinton Election Obama Election, Banking Crisis Balanced Budget Act Budget Battle

12 Federal Expenditures Forecasters IQ Range Index Balanced Budget Act Clinton Election 9/11 Budget Battle Obama Election, Banking Crisis Notes: From the Philadelphia Federal Reserve Survey of Professional Forecasters. Takes the interquartile (IQ) range of the 1-year ahead forecasts (made every quarter) of total federal government expenditures relative to the mean forecast. Normalized to a mean 100 index prior to Aug Sub-component 3b): Federal expenditure disagreement

13 1.Policy uncertainty fluctuates over time, and since 2008 has reached all time high levels 2.Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty 3.Policy uncertainty appears to lower economic growth and raise stock-market volatility

14 Figure 6: Overall & Policy-Related Economic Uncertainty Normalized Number of News Articles Notes: Overall News-Based Economic Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as economic or economy (scaled by the smoothed number containing today). Policy Index set such that monthly average value is 100. Index covers January 1985-July Axis shown as a log scale. Query run on August 11, Bush Election Asian Financial Crisis Gulf War I Russian Financial Crisis/LTCM Clinton Election Dissolution of USSR 1987 Stock Market Crash Recession Fears

15 Note: analysis uses Google news index data

16 Another indicator of the importance of policy uncertainty is it now seems to be the most frequent factor causing stock-market jumps

17 Frequency of 2.5% or greater jumps in the S&P 500 stock market index and the factors underlying this

18 1.Policy uncertainty fluctuates over time, and since 2008 has reached all time high levels 2.Policy uncertainty is now a large (and probably the largest) driver of overall economic uncertainty 3.Policy uncertainty appears to lower economic growth and raise stock-market volatility

19 Why might uncertainty impact the real economy? Economics literature has mainly focused on three channels: Real-options effects: Uncertainty can make firms cautious about investing and hiring Financing costs: Uncertainty can increase risk-premia Precautionary savings: Uncertainty can reduce consumption

20 Figure 8: VAR Estimated Industrial Production and Employment changes after a Policy Uncertainty Shock Industrial Production Impact (% deviation) Notes: This shows the impulse response function for Industrial Production and employment to an 124 unit increase in the policy-related uncertainty index, the increase from 2006 (the year before the current crisis) until the first 8 months of The central (black) solid line is the mean estimate while the dashed (red) outer lines are the one- standard-error bands. Estimated using a monthly Cholesky Vector Auto Regression (VAR) of the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log industrial production and time trend. Data from 1985 to Employment Impact (millions) Months

21 Policy uncertainty also seems to make stock markets more risky (as stocks move together more) Reproduced from Political Uncertainty and Risk Premia, by Lubos Pastor and Pietro Veronesi, University of Chicago, 20 November Political Uncertainty Index is the Economic Policy Uncertainty Index from Baker, Bloom and Davis.

22 Conclusion We are developing a methodology to try and measure economic policy uncertainty over time, with three preliminary results: Policy uncertainty since 2008 has been at all time high levels Policy uncertainty is now a large component (potentially the largest component) of general economic uncertainty Higher policy uncertainty is followed by reduced growth over the following 18 months and increased stock co-movement Continuing to refine the index and extend it back to about 1900

23 BACK-UP SLIDES

24 More on Economic Policy Uncertainty Paper: Measuring economic policy uncertainty, Scott Baker, Nick Bloom and Steve Davis, Stanford mimeo Policy Uncertainty and the Stalled Recovery, Scott R. Baker, Nicholas Bloom and Steven J. Davis, VOX, 22 October

25 Figure 7: Relationship of News-Based Index of Overall Economic Uncertainty to News-Based Index of Policy-Related Economic Uncertainty R-Squared: 0.68 Slope: 0.79 (0.05) R-Squared: 0.88 Slope: 0.98 (0.03) R-Squared: 0.53 Slope: 1.50 (0.19)

26 Figure 9: Robustness of Estimates to Different VAR Specifications Months after the policy uncertainty shock Notes: This shows the impulse response function for GDP and employment to an 124 unit increase in the policy-related uncertainty index. Estimated using a monthly Cholesky Vector Auto Regression (VAR) of the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log industrial production and time trend unless otherwise specified. Data from 1985 to Industrial Production Impact (% deviation) Baseline Reverse order Bivariate (uncertainty and log industrial production) Three months of lags Nine months of lags Uncertainty index has equal weight on measures Adding VIX first as a control for economic uncertainty

27 Figure 10: Quarterly VAR estimates for GDP and investment Months after the policy uncertainty shock GDP Impact (% deviation) Investment Impact (% deviation) Notes: Shows the impulse response function to an 124 unit increase in the policy-related uncertainty index, the increase from 2006 (the year before the current crisis) until the first 8 months of The central (black) solid line is the mean estimate while the dashed (red) outer lines are the one- standard-error bands. Estimated using a quarterly Cholesky VAR: the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log investment, log consumption and log GDP. Data from 1985 to 2011.

28 Figure 11: Estimates after including controls for consumer confidence Months after the economics policy uncertainty shock Notes: This shows the impulse response function for Industrial Production and employment to an 124 unit increase in the policy-related uncertainty index, the increase from 2006 (the year before the current crisis) until the first 8 months of The central (black) solid line is the mean estimate while the dashed (red) outer lines are the one- standard-error bands. Estimated using a monthly Cholesky Vector Auto Regression (VAR) of the uncertainty index, log(S&P 500 index), federal reserve funds rate, log employment, log industrial production and time trend. Data from 1985 to Top panel includes the Michigan Consumer confidence index included as the second variable after our uncertainty index, and the bottom panel includes the Michigan Consumer Confidence index included as the first variable. Industrial Production Impact (% deviation) Consumer confidence included second in the VAR Consumer confidence included first in the VAR

29 China and Japan Competition Index Figure 13: News-Based China and Japan Competition Indexes Notes: News-Based China and Japan Competition Index composed of monthly number of news articles containing competition and economy and Japan or China (scaled by the smoothed number of articles containing today). Query run August 26, Index covers Jan 1985-Aug 2011.

30 Appendix Figure A1: News-Based Energy Uncertainty Index Energy Uncertainty Index Notes: Energy Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as the term energy (scaled by the smoothed number of articles containing today). Google query run June 15, Index covers January 1985-May st Gulf War 2 nd Gulf War Arab Spring Oil Spike

31 Appendix Figure A3: News-Based Middle East Uncertainty Index Middle East Uncertainty Index Notes: News-Based Middle East Uncertainty Index composed of monthly number of news articles containing uncertain or uncertainty as well as the term Middle East (scaled by the smoothed number of articles containing today). Google query run June 15, Index covers January May st Gulf War 9/11 2 nd Gulf War Arab Spring

32 Policy Uncertainty Index 1 st Gulf War 9/11 Clinton Election 2 nd Gulf War Bush Election Balanced Budget Act Lehman and TARP Budget Battle Appendix Figure A4: Equal Weighted Index of Economic Policy Uncertainty Euro Crisis, 2010 Midterms Stimulus Debate Obama Election, Banking Crash Debt Ceiling; Euro Debt Notes: Index of Policy-Related Economic Uncertainty composed of 4 series: monthly news articles containing uncertain or uncertainty, economic or economy, and policy relevant terms (scaled by the smoothed number of articles containing today); the number of tax laws expiring in coming years, and a composite of IQ ranges for quarterly forecasts of federal government expenditures and 1-year CPI from the Phil. Fed Survey of Forecasters. Weights:.33 Google News,.33 tax expirations,.167 CPI disagreement,.167 Fed. expenditures after each index normalized to have a standard-deviation of 1. Google query run August 11, 2011, updated Sept 25 and Nov 8. Index normalized mean 100 before Aug 2011.

33 Policy Uncertainty Index 1 st Gulf War 9/11 Clinton Election 2 nd Gulf War Bush Election Lehman and TARP Appendix Figure A5: Principal Component Weighted Index of Economic Policy Uncertainty Euro Crisis, 2010 Midterms Stimulus Debate Obama Election, Banking Crash Notes: Index of Policy-Related Economic Uncertainty composed of 4 series: monthly news articles containing uncertain or uncertainty, economic or economy, and policy relevant terms (scaled by the smoothed number of articles containing today); the number of tax laws expiring in coming years, and a composite of IQ ranges for quarterly forecasts of federal government expenditures and 1-year CPI from the Phil. Fed Survey of Forecasters. Weights:.35 Google News,.37 tax expirations,.24 CPI disagreement,.04 Federal exp. disagreement after each index normalized to have a standard-deviation of 1. Google query run August 11, 2011, updated Sept 25 and Nov 8. Index normalized mean 100 before Aug Debt Ceiling; Euro Debt

34 Google economic policy uncertainty citation index is highly correlated with a narrower 5-paper index 5 paper index is the frequency of uncertain, economic/y and our key policy terms in the USA Today, Miami Herald, LA Times, Wash Post, and Chicago Tribune, normalized by today Correlation=0.82


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