Fiscal Policy Shifts and Market Volatility: Understanding the Role of Economic Policy Uncertainty (EPU)

This uncertainty arises from potential changes in government policies, such as fiscal reforms, tax legislation, and spending priorities. These policy shifts can create significant market volatility and influence investor behavior.

The Role of EPU in U.S. Fiscal Policy

EPU index captures the uncertainty surrounding future government fiscal policies, which are essential drivers of economic outcomes. As fiscal policies shape economic conditions, any uncertainty around their implementation or changes can have ripple effects on markets. Fiscal policy uncertainty can arise from debates over government spending, tax reforms, or changes to entitlement programs, such as Social Security and Medicare. These areas are central to U.S. fiscal policy, and when their future direction becomes unclear, investor sentiment often falters, amplifying market volatility.

To measure EPU, economists developed an index that combines several key metrics to capture the level of economic policy uncertainty:

1. Newspaper Coverage: This tracks the volume of media coverage from major newspapers discussing economic policy uncertainty. The higher the volume of coverage, the greater the perceived uncertainty.
2. Federal Tax Code Expiration: The U.S. government has numerous tax provisions that periodically expire. The looming expiration of these provisions increases uncertainty regarding future tax policy.
3. Forecast Disagreement: This metric, derived from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, measures the level of disagreement among economists regarding key economic variables such as inflation and government expenditures. A higher level of disagreement reflects greater uncertainty over the future trajectory of fiscal policy.

 The EPU index is calculated for different countries and regions, and can be aggregated into a global index using GDP weights. The index reflects the level of uncertainty about the economic effects of policy actions or inactions by governments, central banks, and other authorities. The index provides a real-time measure of fiscal policy uncertainty and helps to identify periods when uncertainty is elevated due to potential or actual changes in government policies.

U.S. Fiscal Policy Uncertainty in Recent Years

The degree of economic policy uncertainty in the U.S. has increased substantially over the past two decades. Significant fiscal policy events, such as the aftermath of the Global Financial Crisis (GFC) in 2008, the Tax Cuts and Jobs Act of 2017, and large-scale COVID-19 relief packages in 2020, have all contributed to spikes in fiscal uncertainty. The responses to these crises, including stimulus spending and tax reforms, raised questions about long-term fiscal sustainability and the direction of future policy. The uncertainty generated by these events affected not only domestic economic conditions but also global financial markets.

In particular, the COVID-19 pandemic presented a unique challenge for U.S. fiscal policy. Governments worldwide, including the U.S., implemented large-scale stimulus measures to support the economy. This response introduced a new wave of uncertainty, as markets struggled to assess the long-term impact of such large fiscal interventions on the national debt and inflation. Similarly, the Russia-Ukraine conflict, along with global supply chain disruptions and inflationary pressures, has compounded existing fiscal policy challenges, contributing to elevated levels of EPU.

EPU and Its Impact on Financial Market Volatility

The relationship between EPU and market volatility is a critical area of interest for investors. While an increase in EPU does not always correspond to sustained higher volatility, significant spikes in the index often coincide with periods of heightened market turbulence. Fiscal policy uncertainty often drives short-term volatility, particularly around key policy events or government announcements that affect tax laws, spending, or regulatory frameworks.

Despite the increases in EPU levels over the years, long-term equity market volatility does not necessarily mirror these fluctuations. For example, during the Global Financial Crisis (GFC) of 2008, the EPU index rose sharply, but the extent of market volatility during that period was more pronounced than during subsequent fiscal policy debates, such as the Brexit vote or the 2016 U.S. presidential election. While both events saw sharp increases in EPU, the immediate market reactions differed due to the broader economic context in which these uncertainties unfolded.

A more direct link can be observed between changes in EPU and short-term market volatility. When the EPU index rises sharply—particularly in response to major fiscal events—market volatility tends to follow suit. This can be seen during times of policy shifts or periods when the direction of fiscal policy becomes uncertain. Therefore, while high levels of EPU do not guarantee sustained market volatility, they are often indicative of periods of heightened risk and market fluctuations.

Changes in EPU and Their Relationship to Market Volatility

Changes in EPU—rather than the absolute level of EPU itself—are often more predictive of short-term market volatility. When the EPU index shows significant increases, indicating that fiscal policy uncertainty is rising, volatility in financial markets also tends to spike. This is particularly true during major policy transitions or events, such as the introduction of large fiscal stimulus packages or discussions surrounding tax reforms.

In these instances, investors often become more cautious, leading to increased market fluctuations. In the wake of such uncertainty, markets typically wait for clearer signals regarding fiscal policy direction, with volatility subsiding once more information is available about the future trajectory of fiscal policy.

The Broader Implications of Fiscal Policy Uncertainty

While the immediate impacts of fiscal policy uncertainty are most pronounced in financial markets, the long-term effects can extend to the broader economy. Prolonged uncertainty over fiscal policy can hinder business investment, consumer confidence, and overall economic growth. Uncertainty regarding tax laws, government spending, and entitlement programs can create an environment of hesitation among businesses and individuals, leading to lower levels of investment and economic activity.

Furthermore, the long-term sustainability of fiscal policy becomes an increasingly important consideration. The U.S. national debt has been a topic of ongoing debate, and uncertainty about the government’s fiscal path can lead to concerns over the future solvency of key social programs or the ability to address unforeseen economic shocks. These concerns can undermine confidence in both domestic and global financial markets, further exacerbating volatility.

U.S. fiscal policy remains a key driver of economic uncertainty, and the relationship between Economic Policy Uncertainty (EPU) and financial market volatility is a crucial consideration for investors. While increases in EPU do not always result in sustained market volatility, they often lead to short-term fluctuations, especially around key fiscal policy events. The past two decades have shown that periods of heightened fiscal uncertainty—whether in response to crises like the Global Financial Crisis or the COVID-19 pandemic, or in response to debates surrounding tax and spending policies—can have significant impacts on financial markets. As we move forward, the ongoing evolution of U.S. fiscal policy will continue to shape both economic outcomes and market sentiment. Investors must stay alert to shifts in fiscal policy and the accompanying uncertainty to navigate the challenges of an increasingly volatile economic environment.