Browsing through newspaper headlines, one gets the feeling that ‘uncertainty’ will be the buzzword of 2017. The term was used 123 times in the Bank of England’s Monetary Policy Committee minutes. Deutsche Welle described the US President-elect’s absence from the World Economic Forum’s Davos meeting as The Great Uncertainty, while Harvard Kennedy School Professor Carmen Reinhart recently described economic uncertainty as the biggest challenge for policymakers this year.
Policy uncertainty is growing in prominence among academics and researchers, as it has been shown to have significant macroeconomic implications. Baker, Bloom and Davis demonstrate that a decline in economic agents’ capacity to use past information as an accurate indicator of future outcomes tends to lead to increases in stock price volatility as well as overall declines in investment, output, and employment.
In December 2016, the ECB added to global uncertainty with its surprise decision to scale back asset purchases, from €80bn to €60bn. By going against the previous objective of inflation targeting, the institution achieves two things: first, introducing significant uncertainty in how future guidance should be interpreted; second, to remind policy-makers that current risks across the single currency are being increasingly associated with policies put in place to provide stability.
Across the Atlantic, potential upcoming changes to the US policy platform is also increasing uncertainty, as mixed signals are making markets more and more nervous over possible financial market volatility. On the one hand, prospects of pro-growth fiscal policy are being viewed positively, but fears associated with potential disruption of cross-border supply chains due to a protectionist backlash are creeping in.
The Main Issues
On a global scale, as stressed by experts from the Center for Social and Economic Research, the recent resurgence of economic uncertainty relates to issues such as the Trump presidency, the rise of populism in Europe, mixed monetary policy guidance by the ECB, and the discussions surrounding Brexit. These events have substantiated the rise of global economic policy uncertainty to its highest level since the beginning of the 21st century, as measured by Baker, Bloom, and Davis.
However, by explaining the past year’s upward trend of uncertainty strictly in terms of policy expectations, one applies a first-order solution to a second-order issue, understating the persistence of the observed trend. That is to say, the recent resurgence of uncertainty, captured by the Global Economic Policy Uncertainty Index, can be linked to institutional volatility, as policies that threaten the established fabric of institutions are increasingly on the rise.
The Impact on the Real Economy
The reason for highlighting the expectations of persistent uncertainty engendered by institutional volatility is their potential pronounced impact on the real economy: as expectations linked to uncertain future outcomes increasingly guide investment decisions, demand for safe assets rises while spending on capital and labour is retarded. This dampens economic activity today, leading to future actual output growth undershooting its potential level.
Consequently, this underscores a necessity for policy to become more transparent and articulated with forward consistency guidance, in order to avoid a dampening of the current recovery path set out by the EU and the US.
If the continued stagnation of growth in Europe says anything, it is that uncertainty can exacerbate an already sluggish investment environment. This may end up trapping the economy in a sub-optimal equilibrium, with more uncertainty bearing further on potential economic growth.
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