Uncertainty hampering Fed’s and Congress’s stimulus

The uncertainty unleashed by Covid-19 has hampered the stimulus launched by both the Fed and US Congress, says research presented on August 28 at the Jackson Hole conference.

“Policy uncertainty for both fiscal and monetary policy in the US, as well as very high economic uncertainty over what firms and consumers are going to do probably reduced US GDP by something like 2–4% of GDP since the end of 2019,” said author Nicholas Bloom, a professor at Stanford University.

“This is obviously just a part of the 12% drop we’ve seen since this year, but nevertheless is an important component of the big drop in activity.”

In his work, he points to three channels that help to explain why uncertainty represents such an important economic problem. The first is based on the principle that the higher the level of uncertainty, the more firms have to pay a risk premium for investing. This boosts the cost of investing, reducing it overall.

The second channel is so-called real options affects. Companies make decisions that are expensive to reverse, for example investing in a new shop or factory, or hiring. In an uncertain environment, companies are more likely to be cautious, because inaction would seem the option providing more value.

The third negative channel of uncertainty is its impact in reducing the effectiveness of stimulus. Because firms and consumers become more cautious due to the high levels of uncertainty, they react less strongly to monetary and fiscal expansionary policies.

“For example, in normal times every 1% reduction in interest rates leads to, say, a 1% increase in investment. During the higher levels of uncertainty in the pandemic we may see a 1% reduction in interest rates leading to a half-percent increase in investment,” said Bloom. “In a sense, all the good work of the Fed and Congress in trying to stimulate the economy to reduce the impact of the pandemic has been partly undone by uncertainty.”

The flip side is that policies can be designed to tackle the impact of uncertainty. “In a more positive [way], you can see that to the extent to which policy can reduce overall uncertainty, both by being predictable and transparent and also by stabilising the economy, it can help the recovery process.”

Modelling uncertainty

In order to measure uncertainty, Bloom, along with colleagues Scott Baker and Steve Davis, developed models analysing economic news articles and reactions on Twitter. “The model tracks the frequency of newspaper articles on around 2,000 US daily newspapers that discuss economic policy uncertainty,” said Bloom. An automatic scraping algorithm searches for key terms.

Over the last 10 years, the data produced by the model maps out some of the major economic and political events in the US: the debt ceiling debate; the fiscal ‘cliff’; the government shutdown. “What’s striking is the huge surge during the Covid-19 pandemic,” said Bloom. “You can see the weekly index rises to up to 600 points daily during late March and through early April. This is an incredibly elevated level. Regarding newspapers’ frequency of articles, it has gone up tenfold.”

The author highlights a stark contrast between volatility-uncertainty in Wall Street versus Main Street. “What we see is that the measures of uncertainty in Wall Street and Main Street from mid-2019 until the beginning of the pandemic remain flat. And then there is a huge surge in mid-March and early April.”

But afterwards, the Wall Street Vix index drops back to more normal levels. As of August 2020, the Vix was three-quarters of the way back to pre-pandemic levels.

“If instead we look at Main Street we see our firm and newspaper measures still remain incredibly elevated,” said Bloom. “I fear this is going to slow down the recovery. My great hope is that policy, in particular monetary policy, will continue to be stimulative, but also continues to be stabilising and calming the economy.”

The roots of uncertainty

Bloom’s work analysing newspaper articles shows the main roots of uncertainty for the US public are the continuity of fiscal stimulus and the pandemic’s effect on their healthcare coverage.

“In many ways, that’s not so surprising. You will follow the news and see the big debate about whether stimulus will be extended … Healthcare uncertainty is also predictable. This is a health crisis after all, and of course the healthcare industry has been severely impacted,” said Bloom.

“What’s maybe remarkable is that monetary policy uncertainty really hasn’t registered that much of an increase given how active monetary policy has been in the US and internationally,” he added. “That reflects the good work done by the Fed in the sense of being able to be very active and aggressive on monetary policy to stabilise the economy, but also being very transparent and predictable in the sense of minimising the amount of uncertainty that creates as a side effect.”