Causality Between Us Economic Policy and Equity Market Uncertainties: Evidence from Linear and Nonlinear Tests

Abstract

This paper examines the causal relationship between economic policy uncertainty (EPU) and equity market uncertainty (EMU) in the US using linear and nonlinear Granger causality tests. We use daily data on the newly developed indexes by Baker et al. (2013aBaker et al. ( ) covering 1985Baker et al. ( :01:01 to 2013 Results from the linear causality tests indicate strong bidirectional causality. We test for parameters stability, and find strong evidence of short run parameter instability, thus invalidating any conclusion from the full sample linear estimations. Therefore we turn to nonlinear tests. Using Hiemstra and Jones (1994), Diks and Panchenko (2006), and Kyrtsou and Labys (2006) symmetric test, we observe a stronger predictive power from EMU to EPU than from EPU to EMU. (2006) test, we find no evidence of positive predictive power from EPU to EMU. However, we find strong evidence of positive predictive power from EMU to EPU and only weak evidence of negative EPU causing EMU. Performing the causality test using the Sato et al. (2007) time-varying method, we find that the causality between EPU and EMU is not constant over time but rather time-varying. Hence, we implement a sub-sample bootstrap rolling window causality tests to fully account for the existence of structural breaks. Using the intensity plots of the p-values from this, we find evidence that EPU can help predict the movements in EMU only around 1993, 2004 and, 2006. However, we find strong evidence that EMU can help predict the movements in EPU throughout the sample period barring around 1998, 2003 and 2005. Further, the analysis of total effects based on the bootstrap sum of coefficients suggests a positive and stronger causal effect from EMU to EPU but smaller and insignificant causality from EPU to EMU. The implications of these findings for both investors and policy makers are provided.

Uncertainty and crude oil returns

“…The price of oil, however, responds to a global market. Nonetheless, as recently noted by Colombo (2013) and Ajmi et al, (2014), the US EPU measure drives the EPU measure of the major European countries, as well as, Canada, India, and China, implying that a shock to the US EPU a¤ects world-wide uncertainty and, hence, a¤ects the global oil market. Increased uncertainty, however, can also lead to an increase in oil price as oil suppliers can stock-up due to precautionary motive.…”

“…2 Kang and Ratti (2013a), investigate the e¤ect of oil-price shocks on EPU, using a structural vector autoregressive (SVAR) model, estimated with monthly oil data and the EPU index. As in Kilian and Park (2009), they disentangle the oil price shocks according to their origin (i.e.…”

“…That is, did inadequate demand or policy and regulatory uncertainty lead to the economic collapse and slow recovery? 1 To pursue the hypothesis on one side of this debate that the Great Recession and its subsequent slow recovery re ‡ects policy and regulatory uncertainty, Baker et al (2013) develop new uncertainty measures -economic policy uncertainty (EPU) and equity market uncertainty (EMU) indexes. Their innovative approach relies in large part on an automated text-search process of 10 large US newspapers.…”

Economic uncertainty and its impact on the Croatian economy

“…It is also worth mentioning Karnizova and Li (2014), who confirm the predictive characteristics of EPU in forecasting the US recessionary episodes; while Ajmi et al (2015) point to the existence of (bi-directional) Granger causality between EPU and the US stock market yields.…”

Uncertainty and Crude Oil Returns

“…2 Kang and Ratti (2013a), investigate the e¤ect of oil-price shocks on EPU, using a structural vector autoregressive (SVAR) model, estimated with monthly oil data and the EPU index. As in Kilian and Park (2009), they disentangle the oil price shocks according to their origin (i.e.…”