Not all economic policy uncertainty is equal

Source : Option Finance 2 May 2017 issue

Link to the article (in french)

Faced with higher-than-usual uncertainty and a freeze on investments and hiring from companies; a postponement of major spending decisions by consumers and requirements for higher risk premiums from investors would seem intuitively logical. Since mid-2016, however, elevated levels of uncertainty have had seemingly little impact on the economy. While several factors can help explain this situation,  policy makers should not be satisfied with this uncertainty.

Not all uncertainty reflects the risk of bad news

Although much of the uncertainty observed over the past decade has been driven by negative risks, uncertainty is not bad by definition. Consider, for example, the prospect of a potentially large fiscal stimulus package. While financial markets may see increased volatility, linked both to the uncertainty as to the size of the fiscal stimulus and the potential monetary policy response, there is little reason for businesses and consumers in such a situation to delay hiring, investment and/or spending plans. The uncertainty is rather whether they should do more.

Market behaviour and beliefs matter

When it comes to uncertainty driven by a negative risk, investors should be willing to take on positions for this to have a significant market impact. It is not always so. Consider first Brexit. Even if investors had gotten the outcome of the referendum correct, they were still likely to have been wrong footed by the subsequent market reaction. Similarity, the election of President Trump did not result in the expected market reaction; quite the opposite! These are examples where obviously many economic agents prefer to wait instead of acting immediately, even though the result would be well anticipated.

Regulation has also made it much more costly to take leveraged positions. In some aspects, this is good news.   The danger is, however, that central banks now seem to be the only agentsto have the capacity to respond to deep market stress.

In addition, the belief that central banks are both willing and able to step in to stem downside risks remains strong. Looking back to 2015 and 2016, be it with regards to China, to concerns on the strength of the US recovery, to Brexit, or to worries on Greece or Italian banks; the belief that central banks stood ready to act was clearly a powerful force. And, when financial markets do not respond to a negative risk, this will lowers the impact hereof on the real economy. As a general rule, a permanent 10% drop in equities would see 0.1 to 0.2 percentage points knocked off GDP growth in advanced economies in the first year after the shock.

Nevertheless, economic policy uncertainty still matters

While it is tempting to conclude that economic policy uncertainty no longer matters, it is necessary to remain vigilant. It all depends on the nature of the shock, and in particular the speed and amplitude at which it impacts the real economy. Imagine, for example, a supply shock driving oil prices durably back to $100 a barrel. That would quickly erode consumer spending power and weigh on profit margins outside the energy sector. All else being equal, such a scenario would knock approximately 0.5 points off GDP growth in the first year post shock. The question would then turn to the ability of policy to offset the shock. Our concern remains that the transmission of monetary policy to the real economy is weaker today than pre-crisis and all the more so given the current, already exceptionally accommodative, monetary policy.

That leaves fiscal policy as the potentially most effective tool in responding to a large negative shock. That being said, several countries already have elevated levels of public debt and fiscal policy is slow to act. There is no room for complacency and implementing structural reforms to make economies more robust should be a priority. Indeed, this is the warning the President of the European Central Banl. Mario Draghi, issues at every press conference. We can only agree!

Source : Option Finance 2 May 2017 issue

In the event of any differences in translations or interpretations, the French version shall prevail.