Uncertainty dampens the impact of monetary policy

Since 2020, we have seen a rise in uncertainty around the world and in the economy. Examples include the coronavirus pandemic, the war in Ukraine, the energy crisis, rising import tariffs, war in the Middle East and geopolitical tensions. In response to these shocks, the European Central Bank adjusts its interest rates to keep inflation at its 2% target or steer it towards that level. The question is whether an interest rate move always impacts the economy to the same extent.

Uncertainty can cause people and businesses to become more cautious: households may put off making major purchases, and companies may hold off on investment. Banks and financial markets may become more cautious about lending. Consequently, the impact of an interest rate rise may differ in uncertain times compared to a period when the outlook is more stable.

Interest rate rises have a greater impact in stable times

A new DNB Analysis shows that when uncertainty is high, interest rate rises have a different impact compared to when the economic environment is relatively stable. The analysis covers three measures of uncertainty in the euro area:

• Financial uncertainty: turmoil in the financial markets or doubts about financial stability.

• Macroeconomic uncertainty: uncertainty regarding the economic outlook, for example during the coronavirus pandemic.

• Geopolitical uncertainty: tensions relating to international conflicts, security or trade relations.

These measures do not always coincide: each indicator picks up on different forms of heightened uncertainty. This underlines the fact that uncertainty is not a straightforward phenomenon, but can have various causes and manifest itself in different ways.

Figure 1 shows that, for all three forms of uncertainty, an interest rate rise has a greater impact when uncertainty is low. The figure shows the estimated impact of a 25 basis point interest rate rise under conditions of high and low uncertainty, compared with a baseline scenario. The left panel shows the impact on economic growth and the right panel shows the impact on inflation. The dots represent the median effects; the vertical lines (the ‘whiskers’) show the 68% confidence interval. When uncertainty is low, an interest rate rise leads to a more pronounced slowdown in the economy and a fall in inflation. In periods of high uncertainty, these effects are smaller and less apparent. In the event of an interest rate cut, the results show a symmetrical movement in the opposite direction. Particularly when financial or geopolitical uncertainty is high, the impact of monetary policy appears to be weaker. The analysis thus shows that the economic context in part determines the extent to which changes in interest rates affect the economy.

The findings of our analysis do not suggest that monetary policy is ineffective in times of uncertainty. However, it may take longer for the impact to become apparent, or the impact may be less pronounced. It is therefore important for central banks to consider not only the interest rate rise itself, but also the circumstances in which monetary policy is being implemented.

 Given that the impact of monetary policy is weaker in times of high uncertainty, the central bank may be forced to respond more forcefully in order to achieve the desired effect on inflation. In this regard, it is important not to focus on a single measure of uncertainty. Financial markets, the economic outlook and geopolitical tensions can all dampen the actual impact of monetary policy. Central banks must therefore take a range of indicators into account in their assessment.

Uncertainty calls for a flexible and data-driven approach: central banks are constantly reassessing how the economy is responding and whether previous interest rate moves are having the desired effect. Clear communication is key in this regard. After all, central banks must be able to explain what information they use, why their policy is sometimes adjusted and how they continue to work towards price stability.