Figure 1 shows the US-responses of GDP, investment and consumption to a monetary policy shock, for two different levels of uncertainty, as measured by stock market volatility. The red curve is computed holding the uncertainty level at the 90th percentile of its historical distribution. The blue curve is computed holding uncertainty at its tenth percentile.
We see that when uncertainty is low, real activity falls as conventional monetary theory would predict. In contrast, when uncertainty is high the picture looks very different: The policy impulse has only negligible effects.So far, as economic theory predicts.
Our findings indicate that indeed monetary policy is less effective when uncertainty is high. This implies that when uncertainty is high, monetary policymakers may face a trade-off between acting decisively and acting correctly, as policy must be more aggressive than otherwise in order to stabilise economic activity.We could use a definition of 'correctly'.
Our results are consistent with the “caution effect” suggested by economic theory, which maintains that in presence of fixed adjustment costs uncertainty increases agents’ opportunity cost of waiting and therefore makes policy less effective.
Our findings, however, show that the pattern of reduced policy effect is particularly stark when uncertainty measures from financial markets are utilised. This could indicate that financial channels are playing a role. Further research on the exact mechanism behind the policy ineffectiveness effects we find seems warranted.Especially about why there might be uncertainty in financial channels. Say, political posturing. Even, prosecutorial posturing.