Economic uncertainty affects economic decisions

Life is full of uncertainty, but failing to fully address economic uncertainty can have a big impact on consumption, credit and investment decisions.

U.S. households differ significantly in their uncertainty when forecasting their personal and national economic future, according to new research by Camelia Kuhnen, a professor of finance at the University of North Carolina Kenan-Flagler Business School and a faculty fellow at the National Bureau of Economic Research (NBER).

Kuhnen says those most uncertain about their economic expectations are individuals who:

• Have lower income and education levels
• Are women
• Are non-white
• Have precarious work and financial situations
• Live in counties with higher unemployment

That uncertainty affects their economic decisions: Households that are more uncertain are likely to reduce consumption, secure additional credit access and have lower exposure to equity market investments.

Using new data to directly measure uncertainty

Kuhnen conducted the study with Elyas Fermand, a PhD candidate at UNC Kenan-Flagler; Itzhak Ben-David, professor of finance at The Ohio State University and NBER; and Geng Li, chief of the consumer finance section at the Federal Reserve Board. They report their findings in “Expectations, Uncertainty and Household Economic Behavior.”

Measures of households’ uncertainty about economic expectations were not available until recently. Typically researchers have used proxies tied to variability in income growth observed much later than the time when consumption or savings decisions were made, because measuring people’s uncertainty at the time of these decisions directly was difficult.

Kuhnen and her colleagues used new, more accurate data: monthly data from the Federal Reserve Bank of New York’s Survey of Consumer Expectations (SCE) and three special modules – the Credit Access Survey, Annual Housing Survey and Housing Finance Survey.

“Using the SCE data we could better understand the way local economic conditions and individual factors influence household behavior by impacting people’s uncertainty about future economic conditions,” says Kuhnen. “We found novel evidence on the factors that drive uncertainty in economic expectations, and on the effects of this uncertainty on consumption, investment and borrowing decisions.”

“We find a high correlation between how uncertain a person feels about their own future income growth and how uncertain they are about macro-level variables like inflation and home-price appreciation. We demonstrate that people who are more uncertain will behave with more caution when it comes to deciding how much to consume, how much credit to line up, and how much to invest in the stock market.”

Policy interventions and messages

Policy interventions or messages meant to encourage specific behaviors might not have the same impact on all households, says Kuhnen. Examples of such policies or messages include central banks forward guidance, changes in disclosure to consumers about credit products, and changes to ease consumer access to investment products or in the tax implications of such investments.

How they are perceived – and how likely they are to achieve the desired effect – depends significantly on how uncertain a household is about the economic variables the policies are designed to influence. The data indicates that people who are most uncertain when predicting their own or national level economic outcomes are those who have faced more adversity – namely, people of lower socioeconomic status.

Saving and investing

The authors find that households that are more uncertain in their economic expectations –  even accounting for their income or wealth levels – engage in more cautious behaviors. They plan to consume less, line up more credit for rainy days, and have lower exposure to risky financial investments.

For example, a 1 percent increase in uncertainty predicts a 1.2 to 1.5 percentage points lower probability for household to increase their everyday spending. Interestingly, that same increase is associated with lower spending on home renovations, vehicles and trips, but not with home durables like appliances, electronics and furniture.

The authors use household finance data to study the effects of uncertainty on three investment decisions:

• Participation in equity markets
• The proportion of equity holdings to total assets
• The value of equity holdings

They find individuals with higher levels of uncertainty are less likely to invest in equities and have a significantly lower fraction of their assets invested in the stock market, with each 1 percent increase in uncertainty predicting an 8 percent decrease in the value of equity holdings.  Income and net worth are the only two factors that play a greater role in this decision than uncertainty, though education and a lower probability of financial distress also contribute.

Real-world effects

“It’s important to understand how economic uncertainty affects real-world behavior across socioeconomic groups as well as its policy implications,” says Kuhnen.

“Understanding which households are more uncertain is important because responses to policy changes that target economic expectations or behaviors don’t have the same effects on all groups,” she says. “Those who have less clarity about future economic conditions will benefit significantly more from interventions that reduce perceived economic uncertainty.”

And reducing uncertainty could help reduce financial stress. Recent neuroscience research suggests adversity changes brain function, so that people with more adverse backgrounds perceive instability in many domains.

“A reduction in economic uncertainty could have a high impact on population and reduce the cognitive burden imposed by financial stress,” says Kuhnen.