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Into the Unknown: Reflections on Risk, Uncertainty and Monetary Policy Decision-making

Paul Jenkins
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Paul Jenkins: C.D. Howe Institute

C.D. Howe Institute Commentary, 2019, issue 549

Abstract: The contention of this Commentary, using the 2008-2009 Global Financial Crisis (GFC) and related monetary policy decision-making as a case point, is a simple one: that closer attention should be paid to the distinction between risk and uncertainty. As defined by economist Frank Knight of the University of Chicago, risk applies to situations where the outcome of a given situation is not known, but where we can measure probabilities with some degree of confidence. Uncertainty, in contrast, applies to situations where we cannot know all the information we need in order to estimate the probabilities in the first place. It has been standard practice that central banks take into account perceived risks for the economic outlook in their conduct of policy. The Commentary starts with a review of the ways the central banks have traditionally dealt with the distinction between risk and uncertainty using models of optimizing (i.e., rational) behaviour. The Commentary then discusses Agent-Based Models (ABMs), one example of a nonoptimizing behavioural model, in which simple behaviours can combine from the ‘bottom up’ to recreate the more complex behaviours seen in the real world (Turrell 2016). Employing these models could expand the central bank’s toolkit for dealing with risk and uncertainty. The discussion then turns to the importance of communications and why central banks should reposition their communications strategies to better address the distinction between risk and uncertainty. The case is made that expanding their communications strategy to include narratives is a potentially powerful approach for acknowledging there is no pretense on their part that they know what the future holds. By narrative, we mean the ability to integrate information in a way that both acknowledges the infinite uncertainties facing us and tells a story to assist economic agents to understand the world confronting them. For the best policy decisions, a single judgment about the economic outlook is needed, where risks are considered balanced. However, uncertainties may mean that a single judgment is difficult, or near impossible. In today’s world, it seems that economic (and geopolitical) uncertainties have become an almost constant feature of the policy landscape. A growing concern about the true nature and extent of these uncertainties facing policymakers is becoming more commonplace, and for good reason. Three examples are considered, all reflective of the uncertain global economic environment facing Canada. The first is Brexit; the second is the implications for Canada of US-China trade tensions; and the third is climate change. The message of this Commentary is that it is better to acknowledge than ignore these uncertainties as part of a central bank’s modeling and communications strategy.

Keywords: Monetary Policy; Central Banking; Economic Outlook; Policy Guidance (search for similar items in EconPapers)
JEL-codes: E27 E37 E58 (search for similar items in EconPapers)
Date: 2019
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Handle: RePEc:cdh:commen:549