The Role of Uncertainty in the Economy: The Pandemic and Monetary Policies

Uncertainty plays a big role in economics, where markets are often influenced by change and uncertainty. An American economist named Frank Knight makes a distinction between risk and uncertainty in his iconic work titled Risk, Uncertainty, and Profit. He distinguishes that uncertainty applies to situation when one cannot accurately measure the odds of the outcomes, whereas risk refers to those when odds are known. In this case, profit is earned by business entrepreneurs who successfully bear the uncertainties with non-calculable risks.

Although Knight’s statement has struck up discussions, a change in uncertainty does affect consumers and businesses’ behaviors. A general increase in uncertainty would decrease people’s incentives to consume and invest, and this brings negative impacts to the economy. Another way to think about it is that the asymmetric information that investors receive indicates that they are better off waiting for additional knowledge to better make safer investment decisions at a more certain time in the future. This effect usually depends on how uncertain the economy based on people's perception. Uncertainty usually increases in times of a recession or in uncertain scenarios such as trade wars and presidential elections.

The World Uncertainty index (WUI) measures quarterly economic uncertainty over 143 countries with the method of counting the frequency of the word “uncertain” and its variants in the Economist Intelligence Unit (EUI) reports. According to the historical data as shown in image 1, WUI spikes in numerous historical events - SARS virus outbreak, 911 attacks, Brexit vote, the 2016 US presidential election, etc. However, out of all the events it is during the time of coronavirus when WUI spikes up the most. What effects does it bring to the economy when uncertainty reaches its peak during the COVID-19 pandemic?

When the global pandemic hit the world in 2020, the economy was shocked and led many countries into a recession. The pandemic's impacts remain to today. In March 2020, the stock market experienced a big crash as investors were selling out stocks due to the huge perceived uncertainty with concerns about the consequences of the virus. Unlike the risks one would often encounter with known odds, no one knew what was going to happen then; with such high uncertainty, the market remained volatile for a while and eventually led to a global recession. As a result, the FED has adopted various monetary policies in response to the shock to stabilize the market over the year. The actions include lowering the federal funds rate to nearly zero (Image 2), buying treasury bonds and mortgage-backed securities — resulting in lots of cash was injected to the economy.

The Economic Policy Uncertainty (EPU) index is another measure that indicates economic uncertainty, as shown in image 3, a greater EPU is often related to times of recession when GDP starts to decline, and it would drop back to lower levels after a recession ends.

The FED's policies surely improved the economy’s performance over the year. In 2021, the inflation rates in the US has increased immensely (Image 4), this is mainly due to a rise in consumers’ demand along with a lack of supply (all pandemic-related). Under such condition, the FED has recently announced a halt of their quantitative easing policy — dialing back the aggressive bond-buying program. However, a new COVIS variant, Omicron, has been recently contributing to unstable markets, with concerns of the public about the lack of supply and the labor market recovery. It is actually not surprising to see a current decline in the stock market. In fact, when the situation becomes less uncertain, the market should become more stable. “Investors hate to be surprised, particularly by things they don’t understand,” Michael Farr said. “As more facts become known about this omicron variant, Wall Street will calm down and prices will settle where they should.”

A change in uncertainty greatly affects the economy. The recent global pandemic brings immense uncertainty and the economy has been fluctuating around it. Despite the economy being affected by the new Omicron variant, investors believe that big actions won’t be taken by the government. From historical events, at uncertain times like this, it seems like the FED should respond accordingly in order to prevent the economy from collapsing. However, how much should the FED interfere the market remains controversial and it is up for a long-term debate topic.

Sources:

Gregg, Aaron. “Dow Records Worst Drop of 2021 as New Coronavirus Variant Rattles Global Markets.” The Washington Post, WP Company, 26 Nov. 2021, www.washingtonpost.com/business/2021/11/26/stock-market-black-friday/

Phillips, Matt, and Eshe Nelson. “Stocks Fall Again as the Fed Signals It Could End Economic Support Sooner.” The New York Times, The New York Times, 30 Nov. 2021, www.nytimes.com/2021/11/30/business/stock-markets-omicron.html .

“Uncertainty and the Economy: St. Louis Fed.” Saint Louis Fed Eagle, Federal Reserve Bank of St. Louis, 10 Apr. 2021, https://www.stlouisfed.org/publications/regional-economist/april-2013/ uncertainty-and-the-economy#3##3.

“World Uncertainty Index (WUI).” Economic Policy Uncertainty Index, www.policyuncertainty.com/wui_quarterly.html.