We have been getting mileage out of an economic indicator that few know about but it happens to be germane to the current environment. It is the Baker-Bloom-Davis economic policy uncertainty index which scans the news, expected tax changes and economist disagreement to deliver an index on how much or little economic uncertainty is causing anxiety. The assumption is that the more uncertainty, such as Brexit, the more consumers and businesses will put off economic decisions like capital spending, hiring and investments. We bring this up as it is a good piece to work into a monthly dashboard that the bank can leverage for hundreds of uses. Board meeting updates, CEO letters, employee educational pieces and, our favorite, customer-focused newsletters. If you are looking for new and engaging content, this indicator serves to stimulate engagement.
Using The Index
Above, is a recent view of the index that shows the spike around Brexit and then a nose dive. A longer view of the news portion of the index can be found below and an interactive generator plus more information on the index can be found HERE.
This index is interesting these days in that it counters the narrative that either the Republicans or the Democrats are causing businesses to hold off decisions until after the election. We heard this on CNN as well as CNBC in recent days. In fact, support of this narrative could be found in last week’s Fed Beige Book release that mentioned the “headwinds of uncertainty” stemming from the election some eight times in the report.
Part of the value of this analysis is that spikes in the index correspond to times of higher volatility. Having your board, employees and customers educated around this uncertainty helps place the crisis de jour into perspective. Users can gauge how widespread sentiment is on news reports and policy around items like elections, expiring tax laws, debt ceiling challenges or economic shocks.
Put together by three economists, Baker, Bloom and Davis, from Northwestern, Stanford and University of Chicago, respectively, the index goes back to February of 1985 and finds a material relationship between the index and real macroeconomic variables. Further, the research also indicates that a number of large movements in the S&P 500 index, defined as a daily change of 2.5% or more, is a result of policy-related events.
More than just adding perspective, the index can be prescriptive. Increases in the index tend to point to a higher probability of a decline in economic growth and employment in the next several months.
To measure policy-related economic uncertainty, Baker, Bloom and Davis constructed an index from three underlying components. One part quantifies journalistic coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in upcoming years while the third component uses disagreement among economic forecasters as a proxy for uncertainty.
To capture news stories, the index pulls search results from 10 major outlets to include USA Today, Miami Herald, Chicago Tribune, Washington Post, Los Angeles Times, Boston Globe, San Francisco Chronicle, Dallas Morning News, New York Times, and the Wall Street Journal. Search results are included the article talks about economic policy uncertainty and the volume statistics are normalized.
The tax component of the index tracks a report from the Congressional Budget Office (CBO) that details a list of temporary federal tax code provisions. Messrs. Baker, Bloom and Davis annual dollar-weight the impact of the tax code set to expire. The greater the impact, the more effect it will have on the index.
Finally, the third aspect of the index is derived from the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters. Here, the research team utilizes the dispersion between individual forecasters' predictions about future levels of the Consumer Price Index, Federal Expenditures, and State and Local Expenditures to construct indices of uncertainty about policy-related macroeconomic variables.
The result of all three components is an index that has both power and applicability.
Putting This Into Action
If you already produce economic analysis for your board, employees, and customers, consider adding this index into the analysis. If you produce a monthly or quarterly dashboard (and you should), then the index can be added.
Creating a piece of content is a great way for your bank to take a thought leadership position and given the rise of less-than-rigorous quasi-news streams, this index has proven effective for us to help separate the signal from the noise. Give it a try and see if this tool can help make your organization smarter and help better engage your customers.
Submitted by Chris Nichols on September 13, 2016