Tuesday, May 23, 2017

Economy - Two political events triggered an increase in economic policy uncertainty in 2016: the outcome of the UK referendum on EU membership (“Brexit”) and the election of a new US President .. - ECB

Publication - Decoupling policy uncertainty from financial conditions



Introduction

 Two political events triggered an increase in economic policy uncertainty in 2016: the outcome of the UK referendum on EU membership (“Brexit”) and the election of a new US President. In both countries, uncertainty about future economic policy substantially increased after the respective event.

 In the United Kingdom, uncertainties about the nature of economic ties and political relations between the United Kingdom and the European Union to be determined by the outcome of the Article 50 negotiations have emerged.1 In the United States, uncertainty prevails about future trade, political and strategic relations with other countries, the future of financial regulation, and the fiscal and monetary policy stance. The empirical literature on the economic and financial implications of economic policy uncertainty would predict that sudden increases in the latter coincide with rising levels of financial assets’ risk premia coupled with lower economic activity.


In spite of the sharp increase in economic policy uncertainty, investor risk appetite has improved. Despite the increase in economic policy uncertainty recorded in 2016, both US and UK equity price indices have recently reached record highs (see Section 2 of this issue of the FSR), corporate credit spreads have narrowed and asset price-based measures of financial market uncertainty have remained at very low levels. This divergence can be illustrated by two popular uncertainty measures: a news-based measure of global economic policy uncertainty (the global EPU index) and the Chicago Board Options Exchange Volatility Index (VIX), which gauges expectations about future volatility in US equity markets. Historically, the two metrics have been highly correlated (see Chart A.1). In 2016, however, the VIX remained at low levels, while the global EPU index increased sharply in the months after the UK referendum and the US election and has since remained high. 2



This special feature aims to explain the decoupling of economic policy uncertainty and financial conditions. First, it presents some theoretical considerations and previous empirical work on various uncertainty concepts and their impact on financial markets, financial stability and the wider economy. Second, it presents model-based results that can provide ex post explanations for the benign developments in the UK and US financial markets over recent months.



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