Costs of Rising Uncertainty

April 24, 2025

Costs of Rising Uncertainty

Juan M. Londono, Sai Ma, and Beth Anne Wilson¹

At many times over the past five years, uncertainty regarding economic and financial conditions, geopolitical risks, and policy outcomes has been remarkably elevated. Since 2019, selected measures of these uncertainties for the United States, shown in figure 1, have reached their highest levels in decades, with the latest surge coming from economic and trade policy uncertainty (EPU and TPU, respectively). Increasingly, the question is whether high uncertainty has meaningful economic effects and, if so, through what channels. Academic research, especially over the last decade, has provided a richer and more nuanced view of how to measure uncertainty and risk and their economic transmission.² In this note, we review six metrics capturing key uncertainties and risks experienced over the last half decade and highlight the transmission channels identified in the literature for these metrics. We summarize estimates of the economic effects identified in the academic literature and perform our own tests to compare the effects of shocks to the uncertainty measures.

1. The Transmission Effects of Uncertainty

The six measures we select to examine the costs of rising uncertainty illustrate types of uncertainty that have been particularly prominent since 2019. As listed in the first column of table 1, the first two measures capture uncertainty about the underlying behavior of the economy (Real Economic Uncertainty, REU, in Jurado, Ludvigson, and Ng, 2015, and Inflation Uncertainty in Londono, Ma, and Wilson, 2023). REU and Inflation Uncertainty are measures of the unpredictability of the macroeconomy and were particularly elevated during and in the aftermath of the COVID shock. The second two series measure uncertainty regarding policy outcomes, a type of uncertainty that is particularly salient currently (Economic Policy Uncertainty, EPU, in Baker, Bloom, and Davis, 2016, and Trade Policy Uncertainty, TPU, in Caldara et al., 2020). The next measure captures geopolitical risks (GPR) such the Russian invasion of Ukraine or the earlier 9/11 attacks (Caldara and Iacoviello, 2022). The final measure is financial uncertainty, often proxied by the VIX, which was quite high at the start of COVID and rose during the 2023 banking stresses.³

Table 1. Uncertainties and their transmission channels

The second column of the table summarizes the channels identified in the literature through which each type of uncertainty transmits to the economy. Three effects of rising uncertainty are common across measures: (1) delayed or reduced investment and hiring, (2) more cautious consumer behavior, and (3) tighter credit conditions. Facing uncertainty, firms and households tend to postpone investment and larger purchases preferring to shepherd their resources until the underlying conditions are clearer. This behavior is especially prevalent if the outlays are large and irreversible, like sizable capital spending, home or auto purchases, or adding employees. Financial institutions tend to pull back from making risky decisions as well, worsening credit conditions, a feature that is often compounded by a deterioration in sentiment. The appendix expands on each measure and the economic transmission channels highlighted in academic research.

The precise nature of the transmission of uncertainty to investment, consumption, and credit conditions may vary depending on the type of uncertainty. While REU, EPU, and VIX are all associated with investment delays, their economic transmission mechanisms differ: REU stems from unpredictability in broader macroeconomic fundamentals, leading firms broadly to adopt a wait-and-see approach; EPU causes delays in capital allocation until the policy environment is clearer; and VIX affects financial conditions and credit costs, making investment riskier and credit more expensive. Trade uncertainty and geopolitical risks have more global spillover effects: TPU can lead export-oriented firms or those that rely on imports to hold back on investments, raise doubts about supply chains, and keep firms from entering the export market, while geopolitical risks can lead to a pullback in capital flows and add risk premiums to energy and other commodity prices. We should note that uncertainties often have feedback loops with economic activity. For instance, business cycle downturns amplify the uncertainty about future growth (Bloom, 2009). Economic conditions may also influence trade policy decisions, and uncertainty about trade policy decisions can, in turn, have negative economic effects.

Research has also worked to quantify the macroeconomic costs stemming from these channels, and the main findings are summarized in columns 3 and 4 of table 1. Across the metrics, papers commonly find that an increase in uncertainty is followed by a statistically significant drop in industrial production (IP) and investment. More specifically, in response to a one-standard deviation increase in the uncertainty metric, all other things equal, the level of IP tends to fall roughly 1/2 percent and the level of investment declines between 3/4 and 1 percent, although there is variation in the magnitude and duration of the drag across measures. Such declines are not huge, but, considering that over the past five years the various uncertainty metrics have surged 4 to 16 standard deviations from their historical average, a simple scaling points to potentially more economically meaningful declines.

2. Comparing the Strength of Transmission Channels

To assess the economic effects of shocks to uncertainty, most research estimates a statistical relationship between macro variables and the uncertainty metrics controlling for a variety of other factors. The standard technique is to estimate a vector autoregressive (VAR) model that allows one to trace out the effects of uncertainty shocks and address concerns of causality between uncertainty and economic activity; that is, to consider that uncertainty can cause weakness in the economy and economic developments can cause uncertainty to rise.⁴

We use this approach to compare the effects on investment of the six uncertainty measures reviewed. We focus on investment as it is a transmission channel commonly cited in the literature across the metrics. We use the same sample for each metric, running from January 1985 to December 2024, the sample period for which all uncertainty measures are available.⁵ The VAR is estimated separately for each type of uncertainty. Besides uncertainty and investment, to remain close to academic literature, we include the following control variables that are frequently identified as determinants of both uncertainty and economic activity: the national financial condition index from the Chicago Fed, the FED funds rate, and consumption.⁶

Figure 2 shows the estimated responses of investment to a one-standard-deviation shock-a temporary increase over a month before returning to its historical mean-in each type of uncertainty. In all cases, investment posts statistically significant declines.⁷ As indicated above, however, the size, timing, and persistence of the decline varies across measures. For trade policy uncertainty (TPU) and geopolitical risk (GPR), the drop is sharp but short and smaller, which may reflect the fact that these shocks usually hit smaller segments of the economy and, in the past, may have been resolved more quickly. For economic policy uncertainty (EPU) and financial uncertainty (VIX), the drag on investment is more sizable and longer lasting, possibly reflecting the broader nature of the uncertainty and more sustained caution given shocks to financial markets. The largest and most prolonged effects on investment come from shocks to the predictability of the economy (REU), particularly inflation (Inflation U). These shocks may hit broader portions of the economy, and it may take more time for confidence in the predictability of the economy to return for all economic agents. Although a simple exercise, it illustrates the drag to investment regardless of the type of uncertainty but also that the strength and duration of the effects can vary.⁸

The exercise above traces out the effects of a one-standard-deviation shock to the uncertainty measures. However, as mentioned above, the last half decade has seen shocks that have been significantly larger. For instance, geopolitical risk spiked 4.6 standard deviations above its historical mean in March 2022 following the Russian invasion of Ukraine. Real economic uncertainty jumped to 7.7 standard deviations and the VIX jumped to 4.8 in March 2020, while inflation uncertainty reached 3.7 standard deviations in the aftermath of the pandemic. In mid-April 2025, EPU reached a new peak of 8.3 standard deviations above its historical mean, and trade policy uncertainty soared over 16 standard deviations. In figure 3, we scale the estimated responses of investment following a shock in each type of uncertainty corresponding by their maximum spike since late 2019, which notably increases the estimated drag to investment coming from uncertainty.

This is a simple, stylized exercise. Importantly, it does not account for the range of other dynamics and shocks to the economy occurring at the same time, which may exacerbate or moderate the overall dynamics of investment. Nor does it account for potential nonlinear relationships wherein extreme uncertainty events could lead to disproportionate economic effects. This is particularly relevant now given the unprecedented and sustained levels of trade and economic policy uncertainty experienced recently, for which we have yet to observe their economic effects. Finally, we should note that for this exercise, we have focused on investment but, as discussed earlier, uncertainty affects the macroeconomy and financial markets more broadly.

References

Arellano, C., Bai, Y., and Keho, P. J., 2019. Financial frictions and fluctuations in volatility. Journal of Political Economy, 127 (51), 2049-2103.

Bachmann, R., Berg, T., and Sims, E., 2015. Inflation expectations and readiness to spend: Cross-sectional evidence. American Economic Journal: Economic Policy, 7 (1), 1-35.

Baker, S. R., Bloom, N., Davis, S. J., 2016. Measuring economic policy uncertainty. The Quarterly Journal of Economics 131, 1593-1636.

Bekaert, G., Harvey, C., Lundblad, C., and Siegel, S., 2014. Political risk spreads. Journal of International Business Studies, 45 (4), 471-493.

Bloom, N., 2009. The impact of uncertainty shocks. Econometrica 77, 623-685.

Bruno, V., & Shin, H. (2015). Cross-border banking and global liquidity. The Review of Economic Studies, 82 (2), 535-564.

Caldara, D. and Iacoviello, M., 2022. Measuring geopolitical risk. American Economic Review, 112(4), 194-1225.

Caldara, D., Iacoviello, M., Molligo, P., Prestipino, A., and Raffo, A., 2020. The economic effects of trade policy uncertainty. Journal of Monetary Economics, 109, 38-59.

Cascaldi-Garcia, D., Sarisoy, Cisil Londono, J. M., Rogers, J., Sun, B., Datta, D., Ferreira, T., Grishchenko, O., Jahan-Parvar, M. R., Loria, F., Ma, S., Rodríguez, M., Zer, I., 2023. What is certain about uncertainty? Journal of Economic Literature, 61 (2), 624-654.

Handley, K. and Limão, 2017. Policy uncertainty, trade, and welfare: Theory and evidence for China and the United States. American Economic Review, 107 (9), 2731-83.

Hofmann, B., Shim, I., & Shin, H. S. (2020). Bond risk premia and the exchange rate. Journal of Money, Credit and Banking, 52 (S2), 497-520.

Jurado, K., Ludvigson, S. C., Ng, S., 2015. Measuring uncertainty. American Economic Review 105, 1177-1216.

Leduc, S. and Liu, Z., 2016. Uncertainty shocks are aggregate demand shocks. Journal of Monetary Economics, 82, 20-35.

Londono, J., Ma, S. and Wilson, B., 2023. Global inflation uncertainty and its economic effects. Working paper, Federal Reserve Board.

Ludvigson, S. and Ng, S., 2007. The empirical risk-return relation: A factor analysis approach. Journal of Financial Economics, 83 (1), 171-222.

Novy, D. and Taylor, A. Trade and uncertainty, 2020. The Review of Economics and Statistics, 102 (4), 749-765.

Pastor, L. and Veronesi, P., 2013. Political uncertainty and risk premia. Journal of Financial Economics, 110 (3), 520-545.

Rey, H. (2015). Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Appendix: The Transmission Channels of Uncertainty Explored in the Literature

The Real Economic Uncertainty (REU) measure in Jurado, Ludvigson, and Ng (2015) captures the predictability of the macroeconomy; the less predictable, the higher is REU. As the economy becomes less predictable, households and businesses change their behavior, including increasing precautionary savings and postponing expenditures and investment, especially if they are irreversible.⁹ Firms may also delay or even freeze hiring (Leduc and Liu, 2016). Consequently, heightened REU negatively impacts economic activity by dampening investment, consumption, and labor market participation. The economic effects of REU are amplified in the presence of financial frictions, particularly when credit access is constrained (Arellano, Bai, and Kehoe, 2019). During periods of heightened uncertainty, financial institutions become more risk-averse, tightening lending conditions and increasing borrowing costs, which makes it more difficult for firms to secure credit for investment.

One specific type of economic uncertainty is that related to inflation, which was certainly elevated as economies around the world emerged from COVID to face labor shortages, supply chain bottlenecks, and surging commodity prices. Inflation uncertainty arises when businesses, households, and policymakers face difficulty in predicting future price levels. Londono, Ma, and Wilson (2023) find that inflation uncertainty has significant macroeconomic repercussions, particularly through its impact on investment. This impact on investment is explained by two channels that are consistent with the option-pricing theory: a discount rate channel, where rising inflation uncertainty increases both the monetary policy rate and its uncertainty, and a cash flow uncertainty channel linked to the uncertainty about input costs. For households, uncertainty about future inflation expectations influences consumption and savings decisions, often leading to higher precautionary savings and reduced spending (Bachmann, Berg, and Sims, 2015).

Unlike REU and inflation uncertainty, which focus on uncertainty about the underlying behavior of the economy, other types of uncertainty are tied more directly to uncertainty about the direction of policy. Baker, Bloom, and Davis (2016) propose a broad measure of Economic Policy Uncertainty (EPU) tied to uncertainty about government policies and political developments which is based on news articles. Heightened EPU, such as during major elections, debt ceiling negotiations, or fiscal reform debates, are associated with declines in investment, employment, and GDP growth. Firms facing uncertainty about future regulations, tax policies, or government spending tend to adopt a wait-and-see approach, postponing long-term investments and hiring until policy clarity increases. Households also respond to EPU by increasing precautionary savings and delaying major purchases, weakening aggregate demand. The financial market consequences of EPU are also particularly pronounced. When uncertainty over fiscal policy increases, sovereign bond yields rise, and stock market volatility increases (Pastor and Veronesi, 2013).

The Trade Policy Uncertainty (TPU) measure in Caldara et al. (2020) is calculated as the share of news articles discussing uncertainty about trade policy. One key consequence of heightened TPU is its negative effect on trade volumes. When firms face uncertainty over future tariffs and trade agreements, they delay long-term investment and production globally, reducing overall trade flows. Firms hesitate to commit capital to export-oriented contracts if there is a risk of increased tariffs or trade barriers that could make their products more costly, which not only reduces bilateral trade but also disrupts global value chains, where many firms rely on cross-border production to remain operative. Handley and Limão (2017) shows that firms' market-entry or expansion decisions are particularly vulnerable to TPU. As a result, fewer firms enter foreign markets, reducing market competition and leading to inefficiencies in resource allocation. Small- and medium-sized establishments are especially affected since they lack sufficient financial buffers. The negative spillover effects of TPU are particularly pronounced in emerging markets. Novy and Taylor (2020) show that developing countries, especially those who rely on exports as a major driver of growth, are disproportionately affected by trade-uncertainty-induced slowdowns in global demand. When advanced economies impose tariffs or alter trade policies, emerging markets, many of which are part of global supply chains, experience reduced industrial output and slower GDP growth. The ripple effects extend to labor markets, where reduced export demand leads to job losses in export-oriented industries, further dampening consumption and domestic economic activity.

Geopolitical risk tends to be region specific, harder to predict than other types of uncertainty, and highly disruptive to commodity markets and global supply chains. The economic consequences of geopolitical uncertainty are far reaching, affecting corporate investment, trade flows, inflation dynamics, and sovereign risk premia. Caldara and Iacoviello (2022) show that geopolitical shocks, such as military conflicts, political crises, and diplomatic tensions, adversely impact stock markets, corporate investment, and overall macroeconomic activities. Firms react to geopolitical risks by reducing capital expenditures, leading to lower aggregate demand and productivity growth. The economic spillovers from geopolitical uncertainty are particularly severe for countries with high external dependencies on trade, commodities, or foreign direct investment. Bekaert et al. (2014) find that heightened geopolitical risk also increases risk premia in sovereign and corporate bond markets, raising borrowing costs for both governments and firms. When investors perceive geopolitical tensions as a systemic risk, they demand higher yields on bonds, particularly in emerging markets and countries directly exposed to conflict. This leads to capital outflows, currency depreciation, and tighter credit conditions.

Financial uncertainty, often proxied by the VIX, which is the 30-day option-implied volatility of the S&P 500 index, reflects investors' expectations of stock market volatility and is commonly used as a barometer for global risk sentiment. When the VIX rises sharply, it signals increased uncertainty in financial markets, triggering higher risk premia and, potentially, tighter credit conditions. Unlike other forms of uncertainty, which stem from macroeconomic fundamentals or policy shifts, financial uncertainty measured from options is driven by market sentiment, liquidity constraints, and leverage cycles in the financial market. Rey (2015) highlights how VIX-driven financial uncertainty disrupts the global financial cycle, causing rapid portfolio reallocations as investors shift capital away from riskier assets toward safe havens such as U.S. Treasuries and gold. This leads to capital outflows from emerging markets, resulting in currency depreciation, higher inflation, and constrained access to credit. These dynamic raise import costs for emerging economies, fueling inflationary pressures and further straining economic growth (Hofmann, Shim, and Shin, 2020). The effects are amplified when central banks in affected economies are forced to tighten monetary policy to stabilize their currencies, exacerbating domestic economic slowdowns.

Bruno and Shin (2015) documents how heightened financial uncertainty reduces global banks' risk-taking, shrinking cross-border lending. During periods of high VIX, banks tighten credit standards, reduce leverage, and pull back from lending to foreign borrowers. This results in higher borrowing costs for firms and governments, particularly in emerging markets where financial markets are less liquid. The contraction in global credit availability stifles investment, trade financing, and economic activity, making financial uncertainty a significant driver of global economic downturns. In addition, stock market volatility leads to equity sell-offs, eroding investor's wealth and reducing consumer confidence, which in turn constrains discretionary spending and weakens aggregate demand (Ludvigson and Ng, 2007). Moreover, corporate investment delays compound the economic slowdown, as firms facing uncertainty over financing conditions postpone or cancel capital expenditures, reducing productivity growth and employment prospects (Bloom, 2009).