Thoughts

March 21, 2025 | 13:29

Uncertainty Squared

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Everyone craves certainty. Equity investors in particular—the complete loss of which partly explains the recent correction in major U.S. indexes. Apart from the pandemic, U.S. economic policy uncertainty has never been higher in the past four decades (Chart 1). And there’s little doubt why: President Trump’s tumultuous trade policies. Everyone is on tenterhooks awaiting agency reports to the President in early April that are expected to detail a more coherent set of import duties. Even then, the levies could change depending on retaliatory actions and the rate of progress in achieving the Administration’s goals, which include reshoring manufacturing, balancing trade, and border security. The fog may not lift for a while.

Investors detest uncertainty because it often leads to poor financial outcomes. It undermines economic performance, even if the source (like a trade war) never fully pans out. It delays decision-making, deferring consumer spending, notably on big-ticket items such as homes, and business investments, especially large-scale capital projects. It also complicates decision-making, resulting in poor choices that end up misallocating resources. An IMF study found that high policy uncertainty increases downside risks to economic growth, financial market returns, and bank lending. Another study found that extreme uncertainty arising from past major shocks caused large adverse effects on jobs and growth over a six-month span.

Central bankers have an extra reason to dislike uncertainty: it increases the chance of policy errors. Tariff-driven stagflation is particularly hard to handle. It requires separating the downward impact of tariffs on growth from other forces in the economy. For example, it’s unclear whether a recent upturn in U.S. factory production reflects optimism about the Administration’s pro-growth policies, such as planned corporate tax cuts, or is simply the result of tariff front-running. Similarly, separating the upward impact of tariffs on inflation from other longer-lasting forces is difficult. And, unlike in 2018, the Fed is starting off on a sore foot, with inflation holding above the target for nearly four straight years. A policy error could see price pressures take root, notably in expectations, requiring restrictive policy action that triggers a downturn. The best course for central banks may be to wait for the fog to clear, but that runs the risk of falling behind the curve.

Apart from Mexico, Canada has the most to lose if protectionist uncertainty lingers. In fact, its Economic Policy Uncertainty Index went off the rails last month (a nine standard deviation event!). Even prior to tariffs becoming a reality, we trimmed our Canadian growth outlook to account for the effect of uncertainty on business sentiment and investment. This aligned with surveys that suggest many businesses are postponing spending with some even moving production south. A speedy rework of the USMCA might at least begin to part the clouds.