Endogenous uncertainty can turn supply shocks deflationary, amplifying output decline
A Bank of Canada working paper finds that endogenous uncertainty can turn negative supply shocks deflationary, amplifying output decline. This mechanism, quantified using US data, suggests monetary policy can stabilize the output gap.
The fog of imperfect information
A new imperfect-information New Keynesian model demonstrates how procyclical information quality generates endogenous countercyclical uncertainty.
This nonlinear structure allows for a precautionary saving motive, where activity shapes uncertainty and uncertainty feeds back into activity through consumption choices.
The study theoretically shows that this endogenous uncertainty channel operates entirely through aggregate demand.
For negative supply shocks, the induced rise in uncertainty can depress demand sufficiently to dominate the shock's inflationary force, thereby turning the shock deflationary.
This mechanism arises only in sticky-price economies where output is demand-determined, giving monetary policy a powerful role in offsetting cyclical informational imperfections.
The central bank can fully neutralize these adverse effects by closing the output gap, preventing demand recessions triggered by supply disturbances.
Quantifying the deflationary force
The researchers quantify the endogenous uncertainty channel using forecast errors from the Michigan Survey of Consumers, parameterized for the US economy.
They find the channel to be strong enough to generate deflation in response to negative productivity shocks, substantially amplifying the output decline.
This finding challenges the conventional view that negative supply shocks are inherently inflationary, a perspective questioned during the Covid crisis when supply disruptions coincided with deflation.
It also provides a theoretical rationale for observations that tariffs have historically been associated with deflation, partly due to heightened uncertainty during downturns.
The estimated cyclicality of signal precision is statistically significant, highlighting the mechanism's real-world relevance.
Rethinking supply shock responses
The paper offers a compelling theoretical explanation for observed deflationary responses to supply shocks, a crucial insight for current policy debates.
Its quantification using US data provides robust empirical grounding, making a strong case for a more accommodative monetary stance in such recessions.
This work fundamentally redefines the understanding of supply-driven downturns and the appropriate central bank reaction.