Tuesday, April 2, 2013

Uncertainty as a Tool

At the Fed, uncertainty is frequently blamed for dragging down the economy. "There’s no question that slow growth, high unemployment, and significant uncertainty are challenges for monetary policy," John Williams of the San Francisco Fed remarked earlier this year. He added:
There’s pretty strong evidence that the rise in uncertainty is a significant factor holding back the pace of recovery now...More generally, research shows that heightened uncertainty slows economic growth, raises unemployment, and reduces inflationary pressures. This pattern has held over the past three decades, but the effects have been particularly notable in recent years. For example, capital spending has downshifted noticeably since early last year...  The job market also shows the effects of uncertainty...
Williams and other Fed officials have pointed to several sources of uncertainty. The fiscal cliff is an often-cited example, as is the European debt crisis. These sources of uncertainty are basically exogenous to monetary policy, but the Fed itself can also add or reduce uncertainty through its policies and communications. A handful of economists--George Shultz, Michael Boskin, John Cogan, Allan Meltzer, and John Taylor-- wrote in a Wall Street Journal editorial that "The Fed is adding to the uncertainty of current policy. Quantitative easing as a policy tool is very hard to manage. Traders speculate whether and when the Fed will intervene next."

If uncertainty really does have significant effects on the economy, and the Fed really can significantly influence the level of uncertainty, then a logical implication is that uncertainty management is a powerful policy tool. And yet, at least in most countries (with a notable exception that I will get to), this implication does not seem to be taken seriously. For all that policymakers bemoan the effects of uncertainty, they seem reluctant to seriously address it, which makes me wonder if it is simply a convenient scapegoat. Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, called for more accomodative monetary policy in a speech on April 2.
I think that there are several possible approaches available to the Committee. For example, the FOMC could reduce the public’s level of policy uncertainty by clarifying the nature of the economic conditions that would lead the Committee to reduce or stop its current asset purchases....However, [this] would require the FOMC to make relatively complex changes to the language of its current communications.
He ultimately rejected the notion of using uncertainty management as a policy tool, however, calling instead for a lower unemployment threshold.

The notable exception is Turkey, where the central bank deliberately increased uncertainty to address its policy goals. The iMFdirect blog describes the situation:
In mid 2010 the Turkish central bank decided to introduce a policy that increased uncertainty in interest rates hoping that would stop foreign investors who were pouring money into the country in search of a quick buck... The Turkish economy was overheating. Money poured into the country from foreign investors attracted by a strong economy and high yields. A lending boom resulted in excessive growth along with an appreciating exchange rate and widening current account deficit. While evidence of success, these kinds of capital inflows are a headache policymakers would rather avoid, as they expose a country to risks that affect the economy and financial system as a whole, while undermining the objective of controlling inflation... 
Although targeting inflation, in 2010 the Turkish central bank became increasingly vocal about dangers to financial stability. In the absence of a timely response from the banking supervisor, it started to employ less traditional tools with an explicit purpose of addressing both price and financial stability concerns. A cornerstone of the strategy was using policies that created uncertainty.
The uncertainty-generating strategy entailed widening the so-called interest rate corridor. The upper end of the corridor is the overnight lending rate, and the lower end is the overnight borrowing rate. The iMFdirect explains,
In October 2010, the central bank sharply lowered the overnight borrowing rate, at which banks deposit money at the central bank, while keeping the overnight lending rate, at which the central bank lends money to banks, unchanged. By varying the volume of liquidity provided to the markets through repo auctions, which are essentially short-term collateralized loans, it started to generate a lot of volatility in the overnight interbank rate within this widened interest rate corridor... 
Previously, the overnight interbank rates were kept close to the policy rate at which the central bank provides liquidity through quantity repo auctions, indicating the potential rate-of-return for a foreign investor. As the corridor widened, the volatility of the market rates increased. While on average the market rates continued to be close to the policy rate, now it was the “floor” of the corridor that signaled to investors a guaranteed rate-of-return. Lowering it, it was hoped, would deter speculative inflows.
The Turkish central bank also began to provide liquidity to the markets through different repo facilities. By varying the amounts of liquidity provided through these facilities, the central bank could change the cost of lending to banks on a daily basis which creates uncertainty for local banks. Turkish Central Bank Governor Erdem Basci "confounded economists" with his latest move a few days ago. Bloomberg reports that
Economists are split on whether Turkish monetary policy is looser or tighter...BNP Paribas SA, Goldman Sachs Group Inc., Oyak Securities and Ata Invest interpreted the move as loosening policy to focus on boosting growth, while BGC Securities said it was contractionary. Morgan Stanley described it as “neither here nor there” and Finansbank called it “confusing.”
The iMFdirect post writes that it is too early to judge the benefits and drawbacks of Turkey's approach. They point out, and I agree, that the banking supervisor could have employed macroprudential measures sooner to address some of the concerns about excessive growth and capital inflows without the need for the central bank to use uncertainty to address these concerns. Still, it is interesting to see uncertainty added to the toolbox.


  1. The use of monetary policy as a primary policy instrument increases uncertainty and decreases real investment in favour of speculative investment in financial assets, as Kaldor argued. The data agrees.


    "The reader can probably make out from that chart that prior to 1969 the average growth in the rate of investment (red line) was significantly higher than after 1969 when monetary policy (blue line) became an increasingly important tool to manage the economy. The average growth in the rate of investment between 1947 and 1968 was 1.31% per year while the average growth in the rate of investment between 1969 and 2012 was 0.9% – a decline of over 31%. If we take the monetary policy era as having started in 1979 rather than in 1969 – we mention this only because it is the typical periodisation, whereas if we look at the data it’s clear that monetary policy came into favour in 1969 – but if we take the year 1979 as our starting point we achieve broadly the same, if not an even more dramatic, result: between 1947 and 1979 the average growth in the rate of investment was 1.25% per year, while between 1979 and 2012 it was 0.78% – a decline of over 37%.

    Meanwhile, the capital markets have indeed turned into a giant speculative casino. Interest rate targeting is, of course, not wholly to blame for these shifts, but it absolutely is a key factor. And indeed, most economists and policymakers would claim that this era’s prosperity (or lack thereof), which they refer to as the “Great Moderation”, is a result of the new “scientific” interest rate targeting policies. In reality, by using monetary policy shocks to steer the economy central banks are driving out the good investment and encouraging speculative Ponzi rubbish in the financial markets."

  2. In the early 90s it was pretty common for central banks to let the markets in the dark for what was about to happen.

    A friend of mine remembers talking to a senior member of the German Bundesbank at that time, telling him that a rate hike by a central bank should in principle be (my quote) 'big enough to create uncertainty whether the next rate move will be up or down'.

    That kind of policy went out of fashion after the bond market's 'crash' in 1994, when the Fed unexpectedly started raising interest rates quite aggressively.

    Lukas Daalder

  3. Can't one argue that uncertainty has long been in the FED's toolbox? The FED has quite recently made a point of being more transparent on what they do and will do in the near future, and also why. This reduces uncertainty about monetary policy. But this also means that in the past, there was deliberate creation of uncertainty of monetary policy (relative to the present situation.) In other words, uncertainty was used as a tool.

    Apart from that, whenever anyone talks about "uncertainty" you should really substitute "fear". Somehow, uncertainty about positives is never a problem, it is always uncertainty about negatives. For instance, do you think the certainty of the sequester is better than the previous uncertainty about it? Kocherlakota's remark is a good illustration of this. Anyone who does not realize this, will draw the wrong conclusions.

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