Board of Governors of the Federal Reserve System

October 08, 2019

Quantifying the Impact of Foreign Economic Uncertainty on the U.S. Economy

Juan M. Londono, Sai Ma, and Beth Anne Wilson^*

Uncertainty about economic conditions abroad is frequently mentioned as a risk, a cross current, or a headwind to the U.S. outlook. However, there is little evidence linking foreign uncertainty to U.S. economic conditions. One challenge in looking for this evidence is how exactly to measure uncertainty. In this note, we construct a measure of real economic uncertainty (REU), which is based on the predictability of near-term economic performance, for the major advanced economies. We find that an increase in uncertainty about foreign economic conditions is associated with an economically meaningful decline in U.S. industrial production (IP) and U.S. stock prices, even accounting for changes in U.S. REU. Comparing this effect with that of a rise in other global uncertainty measures, we find that increases in REU have a stronger adverse effect on future U.S. economic developments than increases in more sentiment- or news-based measures of uncertainty.

Constructing foreign economic uncertainty

There are many kinds of uncertainty. Our measure focuses on whether a country's economy has become more or less predictable month to month; that is, on how accurately we can anticipate economic conditions in the near future based on what we know now. The less easy the economy is to predict, the more real economic uncertainty there is. We calculate this measure for the seven largest advanced economies (G-7) and Switzerland using monthly data from 1973 to 2018 and the methodology in Jurado, Ludvigson, and Ng (2015) and Ludvigson, Ng, and Ma (2019).

Simply put, to calculate REU, we take a broad range of indicators of the real economy of each country (between 40 to 70 indicators depending on the country), including for output, the labor market, housing, investment, and so on. We build a forecast of each of these real economic variables using a broader set of monthly macroeconomic and financial data (almost 300 indicators), and calculate a measure of how far off our forecasts are from the actual values at each point in time (the time-varying volatility of forecast errors).¹ The further off we are, the more uncertainty there is about economic conditions. Aggregating the measures of the volatility of our forecast misses across all variables for a particular country gives us a REU index for that country. Aggregating across foreign countries (weighting by GDP) gives us a broader measure of foreign REU.² We also construct an analogous measure of U.S. economic uncertainty.

As seen in Figure 1, uncertainty about the real economy in the U.S. and foreign countries tend to increase around recessions (shaded in grey). For example, both uncertainty measures spiked considerably during the global financial crisis. Foreign REU also increased around the time of the euro-area crisis and the Japanese earthquake in 2011.

Figure 1: Real Economic Uncertainty (REU)

The effects of foreign economic uncertainty

To assess the effects of REU (both U.S. and foreign) on U.S. production, we estimate a relation between U.S. monthly IP and risk and uncertainty controlling for other factors that influence IP, including the state of the macroeconomy and financial conditions. Specifically, we estimate a monthly vector autoregression with twelve lags that includes a set of standard variables (in this order ³): the VIX, foreign REU, U.S. REU, log S&P 500 prices, Fed fund rate, log U.S. employment, log U.S. CPI, log foreign IP, and log U.S. IP.⁴

This estimation technique allows us to trace out the effect of increasing uncertainty on the U.S. economy over time (figure 2). Panel A shows that a rise in U.S. REU is followed by a decline in U.S. IP, all else equal. This result accords with other work in the literature using a variety of measures of U.S. uncertainty, such as Jurado, Ludvigson and Ng (2015) and Bloom et al (2018).

The other panels of figure 2 show the effects of increasing foreign REU, the key focus of this note. We find that greater uncertainty about underlying foreign economic conditions (an increase in foreign REU) leads to greater uncertainty about the U.S economy (an increase in U.S. REU)--panel B. Moreover, analogous to our results for the United States, higher foreign REU leads to a significant decline in foreign IP (panel C), though abroad the drag from REU seems initially less strong but more sustained. Finally, an increase in foreign REU is associated with a decline in U.S. IP, all else equal (panel D). Although the effect of foreign uncertainty is smaller in magnitude to that of the U.S. uncertainty, it is statistically significant and economically meaningful. Holding all other variables, including U.S. REU, constant, a four-standard deviation increase in foreign REU, which is close to that observed after the collapse of Lehman Brothers, is followed by a 0.5 percent drop in U.S. IP after one year.⁵ These results suggest that uncertainty about the real economy both at home and abroad amplified the decline in the U.S. economy during the global financial crisis.

Figure 2: Impulse Responses

How does the effect of foreign real economic uncertainty compare to that of other uncertainty measures?

To compare across uncertainty measures, we use two metrics common in the literature: the text-based measure of economic policy uncertainty (EPU) introduced in Baker, Bloom, and Davis (2016), which is an index of article counts containing words associated with uncertainty and economic conditions, and a financial market-based metric of global option-implied volatility, which is closely related to the VIX, and captures how much market participants are willing to pay to protect against outcomes that are far away from average expectations.⁶ EPU is available for the United States and for a global aggregate.⁷ The VIX, although calculated for U.S. equity prices, is almost perfectly correlated with implied volatility abroad and can, therefore, be considered a measure of global uncertainty.⁸ In contrast to our REU, which captures objectively how difficult it is to predict economic activities, both EPU and VIX are more subjectively sentiment-based uncertainty measures.

Figure 3 shows the time series for the global and U.S. EPU and for the VIX. These measures share some common spikes with REU (see Figure 1) but appear to be capturing different aspects of uncertainty. In particular, all uncertainty measures spiked around the global financial crisis. However, the EPU and the VIX are more volatile and moved up notably in 2018, especially the global EPU, reflecting concerns about the policy and growth environment abroad. In contrast, REU measures stayed subdued over the same period, suggesting that the underlying behavior of the economy was not that unusual.

To assess the effects of other types of uncertainty, we use the VAR setup above but replacing foreign REU with either global EPU or the VIX. Overall, an increase in global uncertainty, proxied by either the global EPU or the VIX, is also followed by a significant decline in U.S. IP (left panel of Figure 4). However, the decline in U.S. IP is less pronounced and only marginally statistically significant for the two alternative measures.

Figure 3: Alternative Measures of Uncertainty

We also assess the effect of all three uncertainty metrics on U.S. equity prices.⁹ Irrespective of the metric used, an increase in global/foreign uncertainty is followed by a drop in U.S. equity prices (right panel of figure 4). However, the immediate effect of the VIX is much stronger than that of the other two measures; this result is not only in line with existing literature but also consistent with the stock market uncertainty captured by the VIX. An increase in foreign REU is also followed by a significant and sustained decrease in U.S. equity prices, which is, to the best of our knowledge, a new finding in the literature. Finally, the effect of the global EPU on U.S. equity prices is not statistically significant in medium and long horizons.

Figure 4: Impact of Foreign Uncertainty

In sum, we construct a novel measure of foreign economic uncertainty and provide new empirical evidence that rising uncertainty about real economic performance abroad negatively affects the U.S. economy and U.S. stock prices. The drag from foreign economic uncertainty on U.S. industrial production is additional to that of domestic uncertainty and stronger than that of more sentiment-based global uncertainty measures, such as the VIX and the global EPU. An increase in foreign economic uncertainty is also followed by a significant drop in U.S. equity prices. Our work complements and augments earlier work on uncertainty, providing further evidence of the real economic and financial costs of uncertainty and its international transmission.

Bibliography

Baker, S. R., Bloom, N., and Davis, S. J. (2016), "Measuring Economic Policy Uncertainty," The Quarterly Journal of Economics 131 (4):1593-1636.

Datta, D., Londono, J. M., Sun, B., Beltran, D., Ferreira, T., Iacoviello, M., Jahan-Parvar, M.R., Li, C., Rodriguez, M., and Rogers, J. (2017), "Taxonomy of Global Risk, Uncertainty, and Volatility Measures," International Finance Discussion Papers 1216. Board of Governors of the Federal Reserve System.

Bloom, N., Floetotto, M., Jaimovich, N., Saporta-Eksten, I., Terry, S. (2018), "Really Uncertain Business Cycles," Econometrica 86(3): 1031-1065.

Jurado, K., Ludvigson, S., and Ng, S. (2015), "Measuring Uncertainty," American Economic Review (105-3):1177-1216.

Londono, J. M. (2015), "The Variance Risk Premium around the World," Working paper, Federal Reserve Board.

Londono, J. M. and Wilson, B. A (2018). "Understanding Global Volatility," IFDP Notes. Board of Governors of the Federal Reserve System, January 2018.

Ludvigson, S., Ma, S., and Ng, S. (2019), "Uncertainty and Business Cycles: Exogenous Impulse or Endogenous Response?," American Economic Journal: Macroeconomics, Forthcoming.