The validity of monetary policy transmission depends on the degree of uncertainty in the economy, according to the European Central Bank.
A blog signed by Andrea Falconio and Julian Schumacher reports that in order to achieve a given outcome, central banks may need to act more dynamically during periods of high uncertainty than in low uncertainty.
“This does not mean that central banks should always relax or tighten their monetary policy more aggressively in times of high uncertainty,” it is pointed out.
According to authors, unstable economic conditions are likely to make businesses and households more reluctantly spend on consumption and investment regardless of the actions of the Central Bank.
“While such a slowdown in the activity leans in the same direction in which central banks want to direct the economy during a tightening cycle, it works contrary to the effects that it usually seeks to achieve a relaxation of monetary policy,” it adds.
When economic uncertainty is low, it is added, an unexpected reduction in the interest rate leads to higher inflation and lower unemployment, just as economic theory indicates.
At the same time, when uncertainty is high, the same shock has a much milder impact on the economy. Under these circumstances, economic factors obviously react less to changes in borrowing costs.
For inflation, the maximum effect of a monetary policy, achieved after two years, is about 9 basis points lower and is not different from scratch when uncertainty is high. For unemployment, the maximum effect after one year is about 17 basis points smaller under high uncertainty.
Increase in uncertainty
According to the ECB’s findings, economic uncertainty has recently increased due to geopolitical conflicts and commercial tensions.
It is noted that changes in interest rates make it cheaper or more expensive for businesses to receive a loan or even households to receive a mortgage loan. But when the financial future is uncertain, businesses and households are less likely to invest in large, long -term plans from the beginning. This means that they may not react as much to interest rates as they would react under more predictable conditions.
Changes in monetary policy have a weaker impact on the euro zone economy when uncertainty is high, the authors report
At the beginning of 2025, the index of economic uncertainty reached its highest level than the Covid-19 pandemic. Prior to this, such levels occurred only during the public debt crisis of the euro area. The recent increase is likely to reflect the effects of global commercial friction and geopolitical tensions.