A Random Walk Down the Economic Policy Street: Effects of Economic Policy Uncertainty on Forecasting Future Real Economic Activity in the Euro Area and the UK

Abstract

Recently introduced measure for Economic Policy Uncertainty (EPU) seems to have a role to play in forecasting out-of-sample values for the future real economic activity both for the euro area and the UK economies in the monthly data from 1997-2016. Inclusion of EPU measures either for the US, UK or overall European economies improves the forecasting ability of models based on standard financial market information especially for the period before the 2008 global financial and real economy crisis. However, during and after the most recent crisis period the simple financial market information in the form of the slope of the yield curve and excess stock market returns improves the out-of-sample forecast performance compared to an AR-benchmark model the most. Hence, the EPU information is important in times of 'normal' business cycles, but it might clearly contain similar information components as do the financial market return variables during turbulent crisis periods in the financial markets and real economies.