Assessing the Decoupling of Economic Policy Uncertainty and Financial Conditions

This special feature analyses the recent decoupling between measures of financial conditions and economic policy uncertainty. In 2016, several risky asset prices surged and financial market volatility hovered at low levels while measures of economic policy uncertainty increased sharply, the latter partly triggered by the outcomes of the UK referendum on EU membership and the US presidential election. This special feature attempts to explain these diverging trends. It starts out by reviewing the existing academic literature on uncertainty and its implications for financial conditions. In the empirical part that follows, it provides model-based estimates of the drivers underlying the benign financial conditions prevailing in UK and US financial markets. The results suggest that the adverse impact of economic policy uncertainty on financial conditions in the United States was more than offset by a positive demand shock. In the case of the United Kingdom, however, it was the resolute accommodative monetary policy actions by the Bank of England that supported financial conditions after the referendum. Turning to the euro area, policy uncertainty increased in several countries in the first months of 2017. Looking ahead, further shocks stemming from the political sphere may, in the absence of offsetting factors, tighten domestic financial conditions, increase risk premia and potentially raise debt sustainability concerns. JEL Classification: G00