Intrinsic instability

The global economy faces a long list of uncertainties -growth, inflation, interest rates, political, geopolitical, tariffs, etc. When uncertainty is exceptionally high, as is the case today, the economic environment becomes intrinsically unstable and may evolve suddenly and drastically. This acts as an economic headwind because companies that are highly exposed to these sources of uncertainty may postpone investment and hiring decisions. This may weigh on household confidence, triggering a reduction in discretionary spending. Financial markets may also become more volatile because investors shorten their investment horizon. There is a clear urgency of creating a predictable policy environment.

When discussing the inevitable uncertainties of the economic outlook, central bankers or economic commentators in general, often refer to the balance of risks. ECB President Christine Lagarde stated in her press conference in December that risks to growth remain tilted to the downside. In the US, Fed Chair Jerome Powell recently commented that the FOMC sees the risks to achieving its employment and inflation goals as being roughly in balance. These statements are useful but they only tell us something about the risks that would tip the balance in one or another direction or that would keep each other in check. They do not convey information about a more fundamental question, which is the degree of uncertainty. Is it higher or lower than normal? At the current juncture, we can safely say that it is exceptionally high. The list of uncertainties is long: will the euro area see stagnation rather than subdued growth? Will inflation reaccelerate in the US due to measures taken by the Trump administration (tariffs, deportation of illegal immigrants, tax cuts)? Will the Fed hike rates this year instead of cutting them? Will US import tariffs be raised across the board or only on a selective basis? How will geopolitics influence the economic and market outlook? Will Wall Street continue to ignore the rise in Treasury yields?

Uncertainty is challenging because it forces us to take decisions without having all the relevant information. When uncertainty is abnormally high, the decision challenge increases exponentially. To illustrate this point, let us assume that economic growth depends on the level of inflation, long-term interest rates and the exchange rate. Suppose that when uncertainty is at a normal level, three outcomes can be considered for each variable. For growth, this implies that 27 (33) outcomes are possible, depending on the specific combinations of inflation/bond yields/the exchange rate. When uncertainty is higher than normal for each variable, the range of outcomes is wider. Suppose we now need to distinguish between five possible cases. That would imply that 125 (53) growth outcomes are possible. Admittedly, some or even many can be excluded (e.g. when inflation surprises to the upside, it is unlikely that bond yields would surprise to the downside). However, the feedback loops between the different variables mean that coming to grips with all the interconnections soon becomes excessively complex.

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