The Economic Policy Uncertainty Index Reaches an All Time High
After nearly a month of the shutdown, economic uncertainty is growing alongside political uncertainty. Last week, reports on retail sails, business inventories, housing starts and building permits were all delayed, leaving experts without key reports to gauge the strength of the economy. With the Global Economic Policy Uncertainty (GEPU) Index reaching an all-time high and several months of increased market volatility, uncertainty may be playing an outsized role.
The U.S. Economic Policy Uncertainty Index (EPU) is constructed from three components. The first quantifies newspaper coverage of policy-related uncertainty where national newspapers are searched for articles must contain terms related to the economy, uncertainty and policy. Then the raw count of policy uncertainty articles is divided by the total number of articles in the same paper and month to account for changing volumes over time. The second component draws on reports by the Congressional Budget Office that compiles lists of temporary federal tax code provisions. These temporary tax measures create uncertainty for business and households because Congress often extends them at the last minute, undermining stability and certainty about the tax code.
The third and final component of the EPU index measures the dispersion of forecasts for the consumer price index, purchase of goods and services by state and local governments, and purchases of goods and services by the federal government. In other words, this measures the disagreement among economic forecasters. The overall U.S. forecast is weighted 1/2 on the news-based index, 1/6 on the tax code index, 1/6 on the CPI disagreement measure and 1/6 on the government purchases disagreement measure. The Global Economic Policy Uncertainty Index uses a GDP-weighted average of monthly EPU index values for the 18 national EPU indices.
For irreversible investments such as purchasing machinery or opening new factories, uncertainty raises the value of holding on to cash and waiting to see what happens. Frank Knight’s 1921 paper lays out two concepts of uncertainty: Knightian uncertainty and non-Knightian uncertainty (risk). Knightian uncertainty is not directly measure and unobservable, whereas risk refers to measurable and observable uncertainty (Knight 1921). Put another way, risk applies to situations where we do not know the outcome but we can accurately measure the odds, while uncertainty applies to situations where we cannot know all the information necessary to set accurate odds.
Under Knightian uncertainty, where the uncertainty is not measurable, individuals make decisions as if they held probabilistic beliefs (Savage 1972). The feeling is that even in situations where there is unknowable uncertainty, “people tend to behave as though they had assigned numerical probabilities to the events impinging on their actions” (Ellsberg 2017). However as key economic reports are delayed and measured uncertainty grows, we are moving into increased non-Knightian uncertainty (risk) where decision makers could be discouraged from economic decisions.
SOURCES:
Knight, 1921: Risk, Uncertainty and Profit
Lee, 2017: Three Essays on Uncertainty