Abstract
Abstract This paper analyzes the performance of the monthly economic policy uncertainty (EPU) index in predicting recessionary regimes of the (quarterly) U.S. GDP. In this regard, the authors apply a mixed-frequency Markov-switching vector autoregressive (MF-MS-VAR) model, and compare its in-sample and out-of-sample forecasting performances to those of a Markov-switching vector autoregressive model (MS-VAR, where the EPU is averaged over the months to produce quarterly values) and a Markov-switching autoregressive (MS-AR) model. Their results show that the MF-MS-VAR fits the different recession regimes, and provides out-of-sample forecasts of recession probabilities which are more accurate than those derived from the MS-VAR and MS-AR models. The results highlight the importance of using high-frequency values of the EPU, and not averaging them to obtain quarterly values, when forecasting recessionary regimes for the U.S. economy.
Highlights
Theoretical explanations as to why uncertainty negatively affects economic activity can be traced back to the early works of Bernanke (1983) and Dixit and Pindyck (1994), and more recently in that of Bloom (2009)
We look at a Markovswitching vector autoregressive (MS-VAR) model – where the monthly economic policy uncertainty (EPU) are averaged over three-months to produce quarterly values of the same, and a Markov-switching autoregressive (MS-AR) model, as two possible competitors
To provide a more realistic assessment of the reliability of MF-MSVAR results, we look at a pseudo real-time analysis as proposed by Camacho (2013)
Summary
Theoretical explanations as to why uncertainty negatively affects economic activity can be traced back to the early works of Bernanke (1983) and Dixit and Pindyck (1994), and more recently in that of Bloom (2009). They assert that the interaction between high uncertainty and non-smooth adjustment frictions may lead firms to change their behavior in terms of hiring and investing. To construct the index, Baker et al (2016) perform month-by-month searches of newspapers for terms related to economic and policy uncertainty
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