Publication - Uncertainty about Uncertainty - speech by Kristin Forbes
Uncertainty is the modern equivalent of a “whipping boy” for economics.
A whipping boy was an official court position in the Tudor and Stuart monarchies. The boy was punished when the crown prince misbehaved, even if the boy played no role in the prince’s transgression. Similarly today, “uncertainty” is often blamed for any expected weakness in company earnings or broader economic growth - especially uncertainty around the UK’s relationship with the European Union. For example, about one-third of profit warnings by UK companies in Q3 mentioned uncertainty around Brexit and sterling.1
The BoE’s agents cited uncertainty about the demand outlook and future trade arrangements as the biggest drag on investment intentions in their November update.2 Even the MPC minutes have recently set a record of averaging 15 mentions of uncertainty each meeting, up sharply from averaging less than 6 times per meeting since the Committee was created.3 Despite this heightened discussion about uncertainty, UK economic performance has been solid. Quarterly economic growth has picked up from 0.4% in Q1, to an average of 0.6% for Q2 and Q3. This is well above the consensus expectation by economic forecasters, as well as the MPC forecast. In fact, average GDP growth over the quarters of heightened uncertainty directly before and after the UK referendum on EU membership has been stronger than for all of 2015.
It has even been above what is generally believed to be the UK’s potential growth rate. This raises obvious questions. Are we overestimating the negative economic effects of uncertainty? Is the ease of blaming the “whipping boy” of uncertainty causing us to miss important underlying dynamics in the UK economy? Just as the whipping boy of the 15th and 16th centuries was not always irrelevant to his punishment, however, UK earnings and the broader economy are not unaffected by the uncertainty at hand. The whipping boy was not a poor, innocent, unrelated street urchin. He was a well-born and titled friend of the crown prince. His close relationship with the prince meant that the royal would (hopefully) be less likely to misbehave so that his friend was not whipped.
As a confidant of the prince, the whipping boy could also play a role in encouraging proper behaviour. Similarly, uncertainty around the UK’s future relationship with the European Union has undoubtedly had some impact on companies’ investment plans and the aggregate economy – and will continue to do so in the future. But the key question is: how much?
Figure 1 captures this challenge. The black shaded bars show the MPC’s best collective forecasts for economic growth in Q2 and Q3 of 2016 from the Inflation Report half-way through the relevant quarter. More specifically, the bar for 2016 Q2 shows the growth forecast for Q2 as made in May, and the bar for 2016 Q3 shows the forecast made in August. The green lines show the actual rate of GDP growth (based on the most recent ONS data).
In both Q2 and Q3, actual GDP growth was substantially higher than forecast (by 0.4pp). Next, the red line in each column shows an estimate of growth if the mechanical drag from uncertainty (as estimated using a separate SVAR model similar to that in Haddow et al., 2013) was removed from that quarter’s forecast.4 In each case, growth would have been expected to be higher and closer to actual GDP growth, especially after the referendum, albeit not fully explaining the gap.
Although a series of wellrespected academic papers provide evidence that uncertainty can drag on growth through numerous channels,5 this exercise suggests that mechanically removing the drag from uncertainty from our forecast would have substantially reduced our forecast errors.6 Of course, there are many other factors that could have spurred stronger growth than expected over this period, but overestimating the impact of uncertainty should be in the line-up of suspects.
page source http://www.bankofengland.co.uk/
