Recently, the word uncertainty has been frequently used by the Federal Reserve and the ECB in their communication. It is something they must take into account when taking policy decisions. Likewise, households, firms and investors face different types of uncertainty. That of not exactly knowing the current state of the economy, uncertainty about future economic policy and monetary policy in particular, uncertainty about the transmission of past shocks -including interest rate hikes- and the risk of events -geopolitical, climate-related, etc.- that would have economic repercussions. Every month, the European Commission asks firms and households how difficult or easy it is to make predictions about their future business or financial situation. The balance of opinions captures their economic uncertainty. It seems that, until recently, inflation has been the dominant source of uncertainty but going forward, economic growth should take over this role as the attention will shift to the delayed impact of past increases in official interest rates.
The word uncertainty is omnipresent in recent central bank communication. At the Federal Reserve symposium in Jackson Hole at the end of August, Fed Chair Jerome Powell said that “there is always uncertainty about the precise level of monetary policy restraint”, adding that the assessment of the appropriate monetary stance is “further complicated by uncertainty about the duration of the lags with which monetary tightening affects economic activity and especially inflation.” Also, some shocks to supply and demand in this cycle have been unique and have introduced uncertainty about whether the ensuing dynamics will persist or not.[1] ECB President Christine Lagarde mentioned uncertainty five times in her Jackson Hole speech, emphasizing that “monetary policy should not itself become a source of uncertainty” and that central banks should “talk about the future in a way that better captures the uncertainty we face” in order to maintain their credibility.[2]
UNCERTAINTY: A TAXONOMY
In summary, households, firms and investors face four different types of uncertainty (exhibit 1). The first one consists of not exactly knowing the state of the economy. Households may worry about the risk of losing their job, firms may wonder about the strength of customer demand, etc. We can call this ‘nowcast uncertainty’, i.e. the difficulty of producing a reliable assessment of the current state of the economic and business environment. A second type of uncertainty concerns economic policy, particularly monetary policy at the current juncture: will official interest rates be hiked further and, once the terminal rate has been reached, how long will they stay there? Closely related is the question about the lagged response of the economy to past shocks, monetary and other. The shocks caused by the pandemic, the war in Ukraine, the jump in inflation may still make themselves felt. The lags of monetary policy transmission are also long, variable and impossible to estimate with any precision. This underpins uncertainty about the outlook.[3] Fourth and finally, uncertainty is also influenced by the risk of shocks -geopolitical, climate-related, etc.- that would have economic repercussions.
In the context of its business and consumer surveys, the European Commission has developed an economic uncertainty indicator. To this end, survey participants are asked how difficult or easy it is to make predictions about their future business or financial situation.[4] The charts show the evolution of the uncertainty indicators in recent years in different business sectors as well as for households. Unsurprisingly, the dynamics across industry, services, retail trade and construction are very similar. In 2020, the Covid-19 pandemic caused a jump in uncertainty, which subsequently declined. Last year, the war in Ukraine caused another jump, again followed by a reduction in uncertainty. Consumer uncertainty also increased in reaction to these events, but the biggest jump occurred in the latter part of 2022.
The European Commission surveys allow to explore whether the evolution of uncertainty is related to changes in the economic environment and outlook. To this end, the charts to the left compare the uncertainty indicator with the evolution of business/household confidence. A priori, one would expect a negative correlation. This is the case for households but for business, the correlation was negative when the pandemic struck and when the war in Ukraine started, whereas since the second half of last year, uncertainty has been declining alongside business confidence. Clearly, other factors must play a role.
A possible candidate is the evolution of inflation. When inflation is rising fast and beating expectations, it fuels uncertainty. Firms will be concerned about the evolution of their costs and their possibility to raise prices. Households will be worried about the loss of purchasing power. Business and households may fear higher borrowing costs following the tightening of monetary policy. To explore this, the charts to the right show the evolution of uncertainty and price expectations.[5] For the different business sectors and for households, price expectations and uncertainty have been declining since the latter part of last year.
The decline of headline inflation seems to have reduced uncertainty of economic agents in the Eurozone. A growing feeling that the ECB is close to the terminal rate should bring more relief. With the risk of more rate hikes also disappears that of additional headwinds to growth. However, it will also shift the attention to the headwinds that have already been developing and that may still intensify. Uncertainty will migrate from what will happen in terms of monetary policy to that about the transmission of past rate increases. To put it differently: until recently, inflation has been the dominant source of uncertainty but going forward, economic growth will take over this role.
EUROZONE: CONFIDENCE, INFLATION OUTLOOK AND UNCERTAINTY
William De Vijlder
