In such situations, it is usually argued that the best strategy is to try to avoid the worst outcomes, as we have done in preparing for a no-deal Brexit. And sometimes you need to be bold to avoid truly bad outcomes, exactly as Mario Draghi did when he said that the Eurosystem would do “whatever it takes”. Third, how should we respond to uncertainty about structural relationships? Uncertainty about the transmission mechanism is often used to justify acting gradually. Sometimes described as “tiptoeing in a dark room”, a central banker following the Brainard principle attenuates his response to inflationary shocks if he is uncertain about the precise sensitivity of inflation to monetary policy. But the more cautious he is in the first step, the more ready he should be to take several additional steps: gradualism is not inaction. Structural shifts in the economy are also constantly changing economic dynamics and equilibrium relationships, such as r* (the natural rate of interest) and u* (the natural rate of unemployment). But as John Williams of the New York Fed has pointed out, these stars are today more a fuzzy blur than a single bright point of light. So whilst they can help with the broad orientation of monetary policy, uncertainty about these stars is too wide to permit precise navigation. Overall, therefore, the theoretical guidance on how to respond to uncertainty is itself open, to say the least.
So-called soft data, such as surveys and sentiment indicators, and market signals do not always align with hard official statistics which are generally known with some delay. Statistical techniques exist to try to combine these sources together into a “nowcast” but the error bands around these central estimates are still quite wide. They also cannot deal with one of the most difficult problems: what to make of so-called “idiosyncratic factors”? For instance, to what extent is the recent stutter in the German economy due to the car industry and to the new emissions standards or to the low level of the Rhine and possibly climate change? These are very hard judgements to make. Second, “Future path” uncertainty If we are unsure about where we are, we are even less certain about where we are going, most obviously because of shocks that we cannot precisely predict. A potential slowdown in China or different choices over Brexit – which you will discuss today – are two such examples. Economic dynamics are also driven by underlying momentum that is very difficult to gauge. Is the recent growth slowdown temporary or will it persist? A temporary slowdown is, as you know, the base case for the ECB, which recently revised down its staff macroeconomic projections for real GDP growth substantially in 2019 but only slightly in 2020. Third, “Strategic” uncertainty In some cases, the uncertainty we face is about what other policy makers will do. This is particularly pernicious when unpredictability is considered a source of strategic advantage.