The Role of Economic Policy Uncertainty in Predicting U.S. Recessions: A Mixed-Frequency Markov-Switching Vector Autoregressive Approach

This paper analyzes the performance of the monthly economic policy uncertainty (EPU) index in predicting recessionary regimes of the (quarterly) U.S. GDP. In this regard, we apply a mixed-frequency Markov-switching vector autoregressive (MF-MSVAR) model, and compare its in-sample and out-of-sample forecasting performances to those of a Markov-switching vector autoregressive model (MS-VAR, where the EPU is averaged over the months to produce quarterly values) and a Markov-switching autoregressive (MS-AR) model. Our results show that the MF-MS-VAR fits the different recession regimes, and provides out-of-sample forecasts of recession probabilities which are more accurate than those derived from the MS-VAR and MS-AR models. Our results highlight the importance of using high-frequency values of the EPU, and not averaging them to obtain quarterly values, when forecasting recessionary regimes for the U.S. economy.