2022 was a tumultuous year: NASDAQ, a tech-heavy stock index, closed the year down more than 30%; inflation proved more stubborn than policymakers initially thought and reached 40-year highs; Russia invaded Ukraine, sending commodity prices even higher; and central banks cranked up rates in response, the Federal Reserve raising interest rates at an unprecedented pace in recent history from around zero to over 4%. As we entered 2023, the global economy stood “on a razor’s edge,” the World Bank warned in its latest projections. Add to that a divided Congress with razor-thin majorities, political wrangling over the debt ceiling, and increasingly frequent catastrophic weather events, and it leaves one wondering where we are all headed.
Consumers, managers and investors alike are having to grapple with a great deal of uncertainty about what the future holds. Are we headed into a recession? (Likely.) Does the Fed have inflation under control? (Moving in the right direction, but not quite yet.) What is the outlook at a more micro level locally or for your favorite industry? Or even for noneconomic events like the future of war and climate change? Every day seems to be a mixed bag of good and bad news.
How Unusual Is the Current Level of Economic Uncertainty?
Everyone agrees uncertainty is bad for the economy, but it is also almost impossible to define and measure.1 Instead, economists use a broad range of proxies. Let us take a look at three popular measures.
First, consider the CBOE Volatility Index – also known as the VIX or the “fear index” – which is derived from option prices tied to the S&P 500 stock market index and is a commonly used measure of market uncertainty. It represents the market’s expectation of volatility over the next 30 days. Since peaking sharply in March 2020, when the pandemic brought most of the world to a screeching halt, the VIX has moderated substantially (see Figure 1). It has remained jumpy, however, rising several times into its highest 10% range; it is still elevated, hovering around 25 points on average since the beginning of 2022. That level is undoubtedly greater than its average from the 2010s. On the other hand, it is by no means unprecedented. The 1990s included several events such as the Gulf War and the “dot-com crash” during which the VIX sustained similarly high levels.
A second proxy economists use to measure uncertainty is the degree of disagreement among professional forecasters of economic growth as surveyed by Philadelphia Federal Reserve (Figure 2). The idea is if there is a high level of uncertainty over the outlook, there is likely to be greater disagreement – or dispersion – among forecasters’ estimates. Based on this measure, forecasters appear exceptionally uncertain over the future of the economy, more than they have been at almost any time since the early 1980s. Notably, that period was another marked by high inflation.
The third measure is an index built by Baker, Bloom and Davis to measure the uncertainty around economic policy; it counts how often uncertainty related to policy is mentioned in newspapers by tracking the frequency of words like “regulatory,” “economic,” and “uncertainty.”2 The U.S. version of their index incorporates additional dimensions such as the number of temporary provisions in the tax code along with the degree of disagreement among professional forecasters. The Economic Policy Uncertainty Index (Figure 3) largely mirrors the fluctuations in the VIX – reassuring for the index – but it also shows stronger responses around events that involve major policy concerns. For example, the debt ceiling dispute of summer 2011 and the battle over the “fiscal cliff” in late 2012, stand out in particular – perhaps as a stark reminder of what may be ahead in coming months as another round of debt ceiling negotiations gets underway.
More importantly, however, the EPU Index suggests something more fundamental may be at work. Compared with the 1990s, uncertainty around economic policy has, on average, been consistently greater since the global financial crisis of 2007-08. This is not just in the U.S. It appears to be even more pronounced on a global scale (Figure 4).
The New Normal?
Is uncertainty now anchored at a higher level in a lasting manner? It is hard to say. A pandemic that disrupted supply chains certainly did not help. To what extent those disruptions were temporary will depend on whether global trade gets back on course. However, even before the pandemic and the war in Ukraine, international trade and commerce showed signs of sputtering. Trends like growing nationalism around the world, populist resentment of open borders, and trade wars already sounded alarms on whether the era of globalization is, in fact, over.
A bigger problem might be the greater political polarization and a dysfunctional Congress in paralysis. Political uncertainty on regulation, taxation, expenditure and the enforcement of rules weighs heavily on the business environment. Anxiety around the economic outlook is only made worse if institutions are not trusted to function as they should. That could lead to a situation where uncertainty is sustained at a high level for an uncomfortably long period.
So Why Does It Matter?
Pervasive uncertainty is never good news for the economy. Businesses may hold off on planned investments until the economic outlook becomes clearer – but this also holds for political uncertainty. For example, a recent study using U.S. gubernatorial elections finds that investment declines up to 15% for those firms that are particularly susceptible to political uncertainty.3 Consumers increase their precautionary savings and defer big purchases – as they did in December, for example. Investors demand greater compensation for higher risk in the form of greater credit spreads and higher risk premium, making capital more expensive. As uncertainty amplifies the effects of negative news, both macro and micro growth suffer even more.
All this is bad news for the policymaker whose job it is to find the right mix of monetary and fiscal response. Uncertainty can reduce the level of investment, hiring or consumption, but it also makes economic agents – from businesses to consumers – generally less sensitive to changes in economic conditions. In other words, just when things may be headed in the wrong direction, heightened uncertainty makes economic policy even less effective when it is most needed.
This is particularly challenging at a time when the Fed is trying to determine which it should worry about more – a looming recession or higher inflation.
1 Frank Knight (1921) distinguishes uncertainty from the related concept of risk. Flipping a coin is risky, but the probability distribution over outcomes is known. For a fair toss, there is a 50 percent chance of heads and a 50 percent chance of tails. In contrast, he defines uncertainty as people’s inability to forecast the likelihood of events happening, creating the modern definition of uncertainty.
2 Baker, S. R., Bloom, N., & Davis, S. J. (2016). Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), 1593-1636. https://doi.org/10.1093/qje/qjw024
3 Jens, C. E. (2017). Political uncertainty and investment: Causal evidence from U.S. gubernatorial elections. Journal of Financial Economics, 124(3), 563-579. https://doi.org/10.1016/j.jfineco.2016.01.034
When Uncertainty Becomes a Certainty