Economic policy uncertainty, financial markets and probability of US recessions

• Published in: Economics letters Vol. 125; no. 2; pp. 261 - 265
• Main Authors: Karnizova, Lilia, Li, Jiaxiong (Chris)
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.11.2014; Elsevier Science Ltd
• Subjects: Capital market; Economic forecasting; Economic models; Economic policy; Economic theory; Policy uncertainty; Probit regression; Recession; Recession forecast; Recessions; Securities markets; Stock returns; Studies; Term spread; U.S.A; United States > US; E62; Policy uncertainty; Recession forecast; E52; E44; E32; Term spread; E37; Probit regression
• ISSN: 0165-1765; 1873-7374
• DOI: 10.1016/j.econlet.2014.09.018

We use probit recession forecasting models to assess the ability of economic policy uncertainty indexes developed by Baker et al. (2013) to predict future US recessions. The model specifications include policy indexes on their own, and in combination with financial variables, such as interest rate spreads, stock returns and stock market volatility. Both in-sample and out-of-sample analysis suggests that the policy uncertainty indexes are statistically and economically significant in forecasting recessions at the horizons beyond five quarters. The index based on newspaper reports emerges as the best predictor, outperforming the term spread at the longer forecast horizons. •Economic policy uncertainty indexes (IEPU) help predict future US recessions.•IEPUs improve forecasts from probit models with financial variables.•The results hold for in-sample and out-of-sample forecasts at longer horizons.•The newspaper-based index is a robust predictor at the longer forecast horizons.