1. Measuring uncertainty – including survey measures Presentation at EU workshop on recent developments in business and consumer surveys Brussels, 14 November 2014 Arne Gieseck Adviser DG Economics European Central Bank The view expressed in this presentation do not necessarily reflect those of the European Central Bank.

2. Rubric www.ecb.europa.eu © Outline of presentation EU workshop on recent developments in business and consumer surveys 2 1 2 3 How to measure uncertainty Measuring uncertainty at the ECB Why do we want to measure uncertainty? 4 5 Conclusions and future work How to use EC surveys as measure of uncertainty?

3. Rubric www.ecb.europa.eu © A high level of uncertainty has been a defining feature of the macroeconomic situation since the start of the crisis in 2008. According to economic theory, a high level of economic uncertainty can dampen economic activity, notably via its impact on investment, consumption and employment. When decisions are costly to revert (e.g. as they entail sunk costs or adjustment costs), high uncertainty may lead households or businesses to take a wait-and-see approach, i.e. to postpone action until uncertainty is resolved. Uncertainty can also dampen activity via impact of higher risk premia on cost of finance, and via managerial risk aversion. EU workshop on recent developments in business and consumer surveys 3 Why do we want to measure uncertainty?

4. Rubric www.ecb.europa.eu © Uncertainty is an unobserved variable, and there is no agreed, objective measure of uncertainty available yet Measures proposed in literature include:  Financial market volatility measures  Dispersion in forecasts by professional forecasters  Prevalence of terms such as uncertainty in the media  Dispersion of expectations in business and consumer surveys Combination of measures appears to be good practice EU workshop on recent developments in business and consumer surveys 4 How to measure uncertainty?

5. Rubric www.ecb.europa.eu © Encompassing approach  Financial market volatility measures:  CDS, FX-, Bond- and equity market volatility; ECB systemic stress indicators  Dispersion in forecasts by professional forecasters:  Consensus economics dispersion for real GDP growth, HICP inflation and long-term interest rates, current and next year;  SPF: variance of aggregate probability distribution for GDP, HICP and unemployment projections, current year, 1y, 2y and 5y ahead  Prevalence of terms such as uncertainty in the media:  Political uncertainty index published by Baker et al.  Dispersion of expectations in business and consumer surveys:  EC surveys for manufacturing (Q5), consumer (Q2+4), retail (Q4) and services (Q3)  Yet to come: variance of results from large number of bridge equations EU workshop on recent developments in business and consumer surveys 5 Measuring uncertainty at the ECB

6. Rubric www.ecb.europa.eu © Highest possible frequency – convert then to monthly and quarterly frequencies Earliest possible starting dates Euro area, individual Member States (Germany, France, Italy, Spain, Netherlands), UK, Sweden, Norway, Switzerland, US, Japan, Canada Run seasonal adjustment where needed Normalise all series to pre-crisis period January 1999 - December 2007 Sort individual measures into groups and compile principal component for each group Sort measures by country Plot average of principal components and ranges EU workshop on recent developments in business and consumer surveys 6 Measuring uncertainty at the ECB (ii)

7. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 7 Uncertainty peaked after Lehman and again at height of euro area sovereign debt crisis Following a period of decrease, uncertainty seems to have increased somewhat again in recent months Measuring uncertainty at the ECB (iii)

8. Rubric www.ecb.europa.eu © “Clearly, an indicator of uncertainty that would correct for the influence of the share of ‘unchanged’ replies to the survey would be easier to interpret. Future work should therefore be devoted to disentangling the opposing forces driving the uncertainty measure presented here.” European Business Cycle Indicator, 3 rd quarter 2013, p. 13. Will demonstrate by how much the impact of changes in “unchanged” replies matters or even dominates in EC measure of uncertainty Will propose a different way of calculating uncertainty, which corrects for the influence of “unchanged” replies Will argue that such a measure needs to be interpreted in fundamentally different way EU workshop on recent developments in business and consumer surveys 8 How to use EC surveys as measure of uncertainty?

9. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 9 Uncertainty measure is, in principle, symmetric. Uncertainty at its maximum with zero balance, i.e. equal shares of “+” and “-” The share of “unchanged” replies does not enter the equation, but it matters a lot Any change in share of “=“ implies move from one iso-’unchanged’ replies curve to another Measured uncertainty no longer necessarily symmetric! How to use EC surveys as measure of uncertainty? (ii) + - = B U 20 20 60 0.63 40 20 40 20.75 20 0 80 20.40 20 40 40 -20.75 0 20 80 -20.40

10. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 10 Radical proposal: only the original change in balance between (+) and (-) replies matters Can be used to decompose total change in uncertainty into impact of change in balance and impact of move to other iso-‘unchanged’ reply curve How to use EC surveys as measure of uncertainty? (iii) a) Share (+) = share (+) 0.5*share (=) i.e. absolute difference between (+) and (-) unchanged

11. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 11 Preferred proposal: also ensures symmetric response of uncertainty measure But, for any given balance, uncertainty is the higher, the lower the share of ‘unchanged’ replies (same as in EC), i.e. uncertainty at 50-50 larger than at 20-20 (with 60% (=)) Other than in EC measure, impact of change in ‘unchanged’ replies adds in expected direction to impact of change in balance How to use EC surveys as measure of uncertainty? (iv) b) Share (+) = share (+) *100/(100 – share (=)) i.e. relative difference between (+) and (-) unchanged + - = B U 20 20 60 0 1.0 40 20 40 20.94 20 0 80 20 0.0 20 40 40 -20.94 0 20 80 -20 0.0

12. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 12 Opposing influence of change in balance and change in ‘unchanged’ replies in EC case; large majority of negative replies would have suggested less uncertainty, though. Decline in ‘unchanged’ replies adds to decrease of measured uncertainty in proposal How to use EC surveys as measure of uncertainty? (v) Contribution of changes in balance and changes in share of ‘unchanged’ replies to total change in measured uncertainty a) EC measure b) Proposed measure

13. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 13 Interpretation of both measures is fundamentally different! EC measures centred on values of low uncertainty, with outliers notably to the upside, suggesting periods of high uncertainty Proposed measure is symmetric. Shows large number of periods with high uncertainty, i.e. when balance close to zero. Shows some periods with (very) low uncertainty, i.e. when balance either very positive or negative. Measure suggests then, that agents are certain about the direction! How to use EC surveys as measure of uncertainty? (vi) Uncertainty as measured by manufacturing survey, Q5; Density function, 1999-2014

14. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 14 EC measure shows relatively low uncertainty in good periods, rather high uncertainty in bad ones – i.e. is asymmetric in case of manufacturing survey Proposed measure suggests low uncertainty in good periods, and low uncertainty in bad periods, i.e. is symmetric. How to use EC surveys as measure of uncertainty? (vii)

15. Rubric www.ecb.europa.eu © It is important (but difficult) to have broad-based information on prevailing uncertainty Proposed measure improves on existing one: –is symmetric by construction –offers intuitive interpretation –Captures envisaged role of ‘unchanged’ replies Proposed measures requires different interpretation! Future work –Proposed measure for uncertainty requires different econometric approach to capture its impact, but might be more complementary than existing measure –Develop other measures to capture uncertainty EU workshop on recent developments in business and consumer surveys 15 Conclusions and future work

16. Rubric www.ecb.europa.eu © Thank you very much for your attention! EU workshop on recent developments in business and consumer surveys 16

17. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 17 Background: How to use EC surveys as measure of uncertainty?

18. Rubric www.ecb.europa.eu ©EU workshop on recent developments in business and consumer surveys 18 Background: How to use EC surveys as measure of uncertainty?