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How to measure economic uncertainty

Measures of economic uncertainty help investors to track popular fear or complacency for the purpose of trading strategies. Academic papers propose various methods: keyword frequencies in news, equity market volatility, earnings forecast dispersion and economic forecast disagreements. Composite measures suggest that uncertainty typically rises abruptly but declines just gradually.

Moore, Angus (2016), “Measuring Economic Uncertainty and Its Effects”, Reserve Bank of Australia, Research Discussion Paper, 2016-01. 
Baker, Scott R. , Nicholas Bloom, and Steven J. Davis (2015), “Measuring Economic Policy Uncertainty”, NBER Working Paper No. 21633, October 2015.

This post ties in with the subject of “the importance of tracking macroeconomic change” in the summary on macro trends.
Tracking economic uncertainty consistently is “expensive” and hence markets are probably “rationally inattentive”, as explained in a previous post, suggesting that there is an opportunity of genuine value generation.

The below are excerpts from the papers. Most quotes are from the RBA paper; the NBER paper quotes are marked specifically. Headings, links and cursive text have been added.

The unobservable

“In this context, uncertainty refers to…lack of…clarity…about future economic activity…Uncertainty…is not directly observable. In response, economists have developed a large and active literature that attempts to measure uncertainty…Commonly used proxies of uncertainty…include: newspaper-based measures of uncertainty…finance-based measures…and measures of disagreement among forecasters for key economic variables.”

News-based measures of uncertainty

General approach

“To capture uncertainty reflected in media coverage, I…construct a measure of newspaper articles that reference economic uncertainty…I search a database of newspaper articles (Factiva) for economic uncertainty-related articles. To meet the search criteria an article must contain ‘economy’ (or variants) and ‘uncertain’ (or variants) and at least one of the following terms: ‘budget’, ‘policy’, ‘legislation’ (or variants), ‘regulation’ (or variants), ‘parliament’, ‘senate’, ‘reserve bank’ or ‘RBA’… For each newspaper, I measure the number of articles that match the criteria relative to the total number of articles published in that month.”


News-based measures of economic policy uncertainty (Baker et al, 2015)

“To investigate the role of policy uncertainty, we first develop an index of economic policy uncertainty for the United States and examine its evolution since 1985. Our index reflects the frequency of articles in 10 leading US newspapers that contain the following triple: ‘economic’ or ‘economy”; “uncertain’ or ‘uncertainty’; and one or more of ‘congress’, ‘deficit’, ‘Federal Reserve’, ‘legislation’, ‘regulation’ or ‘White House’. To push back to 1900, we rely on archives for six major US newspapers published throughout the last century….this long-span EPU index highlights pre- World War II political developments and shocks like the Gold Standard Act of 1900, the outbreak of World War I, the Versailles conference in 1919, and a sustained surge in policy uncertainty from late 1931 when President Hoover, and then President Roosevelt, introduced a rash of major new policies. The index also shows an upward drift since the 1960s, perhaps due to rising political polarization or the growing economic role for government. Using similar methods, we construct…indices for eleven other countries, including all G10 economies.”


“First, we show a strong relationship between our measure of economic policy uncertainty and other measures of economic uncertainty, e.g., implied stock market volatility.”


“We conducted an extensive audit study of 12,000 randomly selected articles drawn from major US newspapers. Working under our close supervision, teams of University of Chicago students underwent a training process and then carefully read overlapping sets of articles. We use the audit results to…evaluate the performance of our computer-automated methods, and construct additional data. There is a high correlation between our human- and computer-generated indices (0.86 in quarterly data from 1985 to 2012 and 0.93 in annual data from 1900 to 2010). “

“Commercial data providers that include Bloomberg, FRED, Haver and Reuters carry our indices to meet demands from banks, hedge funds, corporates and policy makers. This pattern of market adoption suggests that our indices contain useful information for a range of decision makers.”

Finance-based measures of uncertainty

Equity volatility-based measures of uncertainty

Stock market volatility is a commonly used proxy for uncertainty because it is available in real time and is reasonably comparable across countries…

  • Realised volatility measured here by the monthly average of the daily absolute percentage change… is one measure of stock volatility. The main benefit of this measure of stock volatility is that it provides a very long time series…
  • A measure of forward-looking stock market volatility can be constructed from the implied volatility of call and put options…It represents the expected one-month-ahead volatility…Unfortunately, data for option-implied volatility are more limited.”


Earnings forecast dispersion-based measures of uncertainty

“Another finance-based measure of uncertainty is the dispersion in analysts’ forecasts for 12-month-forward earnings…The benefit of this measure is that it is more directly connected to economic activity – corporate profits are part of GDP – than measures of stock volatility. It is also quite timely, although less so than stock volatility measures. However, it has a much shorter history than most other measures…The measure is calculated as the cross-sectional coefficient of variation of analysts’ forecasts.”


Economic forecast disagreement-based measures of uncertainty

“Measures of dispersion between forecasters for economic variables can also proxy for economic uncertainty. Heightened economic uncertainty widens the potential distribution of outcomes; this should show up as greater dispersion among forecasters…Forecast dispersion measures are closely conceptually connected to economic activity. Moreover, these measures are timely – for instance, the Consensus Economics survey is typically conducted in the early part of the month and the responses are published shortly thereafter.

“There is a reasonable degree of correlation between the different measures of forecast dispersion…across both different surveys and different forecasted variables. These correlations suggest that there is a common element that drives dispersion among forecasts for different economic variables.”


Stylized facts of aggregate uncertainty

“Measures of forecast dispersion are only modestly correlated with the finance-based measures of uncertainty and are uncorrelated with the newspaper-based measure.”

I use four measures to construct a monthly economic uncertainty index for Australia…economic uncertainty-related newspaper articles; forward-looking stock market volatility; analyst earnings forecast uncertainty; and GDP growth forecast dispersion…The index is a weighted average of the standardised components. The weights are: 50 per cent on the newspaper-based measure [capturing policy uncertainty]; one-sixth on each of the remaining three measures.”

“The index lines up with events that a priori might be expected to create economic uncertainty.”



“I use the index to document some stylised facts about economic uncertainty…

  • Economic uncertainty is estimated to be countercyclical. It is about two-thirds of a standard deviation higher when unemployment is rising…
  • Economic uncertainty tends to increase faster than it decreases and periods of high or low uncertainty tend to persist…The dynamics of uncertainty are often characterized by large spikes upward after major events, followed by slow reversion
  • Economic uncertainty is estimated to be higher than average before federal elections and in the month of the election… The uncertainty around elections is probably related to how close the election result is…Estimated economic uncertainty declines following elections…
  • Economic uncertainty index is…correlated with ‘monetary policy surprises’…I measure ‘monetary policy surprises’ by the absolute difference between the market-implied cash rate the day before a cash rate decision and the subsequent decision. “

“I also use the index to estimate how uncertainty affects the economy… The Australian evidence is consistent with…[economic] theories: heightened uncertainty is estimated to weigh on economic activity… I find that higher uncertainty [i] weighs on employment growth, [ii] reduces machinery and equipment investment growth and [iii] raises the household saving ratio.”

“[U.S. econometric analyses] indicate that a policy uncertainty innovation equivalent to the actual economic policy uncertainnty increase from 2005-06 to 2011-12 foreshadows declines of about 6% in gross investment, 1.2% in industrial production and 0.35% in employment.” [Baker et al., 2015]


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