WASHINGTON (Reuters) - Uncertainty is rampant in financial markets and businesses, and for the first time economists can measure how big a bite it takes out of growth.
The models show that not only political uncertainty hurts output. So too can Federal Reserve policy.
When Fed interest rates are near zero and most designed to support growth, uncertainty can get further heightened making it even more damaging than in normal circumstances with higher drops in output. The knowledge that the Fed cannot cut rates further feeds uncertainty, and it also can worsen inflation.
The projections by a handful of leading economists show that the market upheaval unleashed by August's U.S. debt debacle has not yet worked its way through the U.S. economy.
It will rob an estimated 1.75 percentage points from output with the full impact hitting in the first quarter of 2012, heightening the risks of recession next year.
The findings are laid out in two new papers from economists at Boston College and in a working paper issued by the Philadelphia Federal Reserve Bank that build upon recent work at Stanford University.
The studies come just as slow growth is dogging policymakers and the Fed is under attack for its ultra-loose monetary stance.
They are likely to fuel arguments about what the proper role of the Federal Reserve should be and could provide fodder to U.S. lawmakers who argue the central bank should focus solely on fighting inflation.
The studies also underscore the risks from both sides of the Atlantic as policymakers in Europe and the United States grapple with resolving deep sovereign debt problems.
At a minimum, the models estimate that elevated levels of uncertainty rob 0.3-0.5 percentage points from output.
Business people and economists know well how investment and spending get put on hold when uncertainty rises.
Take Rose Corona, owner of Corona Ranch, a farm and feed store in Temecula, Calif.
Over the past two years, she has canceled plans to build a $70,000 hay barn, postponed replacing a $20,000 generator to pump well water and is waiting before she fences her grapefruit groves. She also laid off nine of her 35 employees.
Her annual revenues have fallen below $5 million since the 2008-2009 recession and her costs have soared. Now she is concerned by talk in Washington about regulating dust stirred up by plowing and about higher taxes for the rich. This double whammy of weak demand and uncertainty over business conditions is restraining her investment plans.
"If I have to pay more taxes, is it going to allow me to hire more people? You don't pull up the weak by pulling down the strong. We all need to help but there is only so much blood I can give," Corona said.
Now economists have a way to model the impact.
Stanford University economist Nicholas Bloom used the Chicago Board Options Exchange VIX Index of stock market volatility as a proxy for uncertainty. When it spikes above 40, output growth falls by about 2 percentage points in the next six months and takes about nine months to recover, he found.
Building on his work, Boston College economists Susanto Basu and Brent Bundick built a model that shows that when uncertainty about future demand as measured by the VIX rises by one standard deviation, it reduces growth by 0.3 percentage points over the following year.
When Fed rates are very low, the uncertainty impact is amplified by 50 percent, they found.
After the collapse of Lehman Brothers, for instance, a shock that caused massive financial upheaval worldwide and led the Fed to slash interest rates toward zero, their model found uncertainty contributed 2.5 percentage points to the steep decline in Gross Domestic Product over a one year period.
"High uncertainty creates low demand by inducing households and firms to cut back on spending in order to build up nest eggs for possible bad times in the future, and low demand in turn reduces growth and employment," Basu said.
A model developed by economists at the University of Pennsylvania, Duke University, and the Phillie Fed came to similar conclusions, although it focused explicitly on fiscal uncertainty.
The researchers looked at four factors -- uncertainty over the path of government spending, labor tax, capital tax and consumption tax -- and found that when all four are elevated by two standard deviation points, output is depressed by 0.5 percentage points.
The impact of this fiscal volatility shock is equivalent to the Fed raising interest rates by 25 basis points, but it lasts about twice as long with the steepest decline in output seen three quarters after the shock, the researchers said.
They also found like Basu that when monetary policy is extremely loose, it magnifies the impact of fiscal uncertainty.
Additionally, businesses tend to raise prices in anticipation of higher marginal costs and to secure their profits against declining sales, causing inflation even as output is falling.
The researchers conclude that in response to fiscal uncertainty, the Fed would do better to concentrate more on inflation than on job growth."
"We find, interestingly, that a stronger focus of monetary policy on inflation, rather than on employment, alleviates the negative outcomes of fiscal volatility shocks on economic activity," they said.
Some U.S. lawmakers are proposing limiting the Fed's mandate to inflation-fighting only.
Basu said he was surprised that his model showed a negative growth impact when Fed rates are near zero, and it suggests that a combination of fiscal and monetary policy is needed to jump start the economy.
"It gives a lot of support to those who say that zero-bound interest rates are a major constraint on Fed policy, and we need to use fiscal policy to further support growth," he said.
(To read the papers:
Federal Reserve Bank of Philadelphia working paper series, "Fiscal Volatility Shocks and Economic Activity" by Jesus Fernandez-Villaverde, University of Pennsylvania; Juan Rubio-Ramirez, Duke University; Pablo Guerron-Quintana and Keith Kuester, Philadelphia Fed, double-click: here
Boston College paper: "Uncertainty Shocks in a Model of Effective Demand" by Susanto Basu and Brent Bundick: here )