It’s become standard practice, too, to assume that decision-makers are hyper-rational in how they form their expectations of future policy and future events; they are assumed to fully understand how the economy works. To be sure, the economy is subject to shocks, so that its course is unpredictable. But that uncertainty, according to this school of theory, is of no real consequence for households’ decisions about how much to save and consume, or businesses’ decisions about how much to hire and invest. The technical term is “certainty  BIS central bankers’ speeches  1  equivalence”: In standard models, choices depend on what you expect will happen and not on the degree to which you are confident in your predictions. Such thinking is far removed from reality and, thankfully, there’s increasing recognition of that fact. A variety of uncertainty indexes have been developed and their importance in theory and in practice examined.1 Pretty uniformly, these studies suggest that changes in uncertainty have significant economic effects and that uncertainty has been elevated in recent years. In theoretical analyses, the impact of uncertainty is especially great when realistic financial and informational frictions prevent risk from being spread optimally. Because of such frictions, for example, debt contracts often require that borrowers post collateral. When uncertainty increases, so do collateral requirements, tightening credit and increasing the value of “safe” assets relative to other assets.2 There’s more than one type of uncertainty.

Simultaneously, the Fed tried – and I emphasize tried because the message seems to have been garbled in the minds of some intended recipients – to influence expectations of its own behavior once asset purchases have run their course. These “asset-purchase” and “forward-guidance” policies are relatively unfamiliar, and their impact is uncertain. 6  See “Assessing the Costs and Consequences of the 2007–09 Financial Crisis and Its Aftermath,” by David Luttrell, Tyler Atkinson and Harvey Rosenblum, Federal Reserve Bank of Dallas Economic Letter, vol. 8, no. 7, 2013, www.dallasfed.org/research/eclett/2013/el1307.cfm. 4  BIS central bankers’ speeches  One implication is that aggregate fiscal shocks – and, hence, also aggregate fiscal uncertainties – are likely to have outsize effects in current circumstances. Contractionary fiscal policy that would ordinarily drive down interest rates, providing offsetting stimulus to private expenditure, will have a larger-than-typical economic impact because this “crowding in” is absent once interest rates are confined to the zero lower bound. Expansionary fiscal policy, similarly, will fail to “crowd out” private expenditure if interest rates hold steady. Second, because the zero bound complicates the conduct of monetary policy and shortcircuits fiscal crowding out, it introduces a “kink,” or discontinuity, in the economy’s behavior. The existence of a kink means that uncertainty matters even if ordinarily it would not: “Certainty equivalence” no longer applies. When real growth and/or inflation prospects are weak – so that the economy is operating near the zero bound – downside risks to growth and inflation loom larger than they ordinarily would.