July 18, 2019 – Radical uncertainty about the economic outlook is posing a new challenge for the Bank of Canada and other central banks, according to a new C.D. Howe Institute report.
In “Into the Unknown: Reflections on Risk, Uncertainty and Monetary Policy Decision-making”, author Paul Jenkins assesses the need for central banks to add to their toolkit with ‘bottom up’ agent-based models and to reposition their communications strategy through the use of narratives—both to help address what we mean by true uncertainty.
“The events leading up to, during and, after the fallout of the 2008 to 2009 Global Financial Crisis have made it clear that our ability to project economic activity – both domestic and global – is considerably less than previously assumed,” states Jenkins.
The report contends that central banks should pay closer attention 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, notes Jenkins, a former Senior Deputy Governor of the Bank of Canada. They have used so-called optimizing (rational) models in which agents are fully rational, knowing what shocks have occurred, the persistence of such shocks and how the shocks are propagated.
Jenkins argues that central banks could expand their toolkit with agent-based models that account for irrational, non-optimizing behavior. Drawn from the literature on behavioural economics where ‘animal spirits’ has become a common term, agent-based models include simple behaviours (or rules) that add up to real-world complexity.
In the uncertain global environment, says Jenkins, the Bank of Canada and other central banks should also strengthen their communications strategies with narratives to help economic agents understand the world confronting them. He cites Brexit, US-China trade tensions and climate change as reflective the uncertain global environment facing Canada.
“It is better to acknowledge than ignore these uncertainties as part of a central bank’s modelling and communications strategy – that is, there is no pretense that we know with any precision what the future holds,” notes Jenkins. “More honesty with the use of narratives can encourage firms and individuals to take more responsibility for their actions.”
For more information contact: Paul Jenkins, Senior Fellow, C.D. Howe Institute and Adjunct Professor, Carleton University; or Nancy Schlomer, Communications Officer, C.D. Howe Institute, phone 416-865-1904 ext. 0247, email: nschlomer@cdhowe.org.
The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.