The self-fulfilling prophecy of uncertainty : a study on the impact of uncertainty and contagion on economic outcomes and policy

Abstract

Economic globalisation has ushered in the integration of world financial markets, and the degree of interconnectedness has never been greater. In the face of a resurgence in global risks from trade, geopolitical tensions and global health risks, such as the outbreak of COVID-19, there has been an increasing focus on the impact of uncertainty on economic outcomes. Overall, uncertainty has been found to have significant negative impact on economies with the potential to compound recession and hinder economic recovery. The principal objective of this study is to address the impact of uncertainty and contagion on economic outcomes and policy in the South African context through a broad focus on the key markets – including the stock market, the currency market and the goods market – with particular focus on non-linear modelling and asymmetric effects, where the sign and size of a shock or uncertainty within markets have different impacts. In order to meet this objective, this study first investigates the interdependence and volatility transmissions and contagion between the stock and currency markets through a bivariate Exponential Generalised Autoregressive Conditional Heteroscedasticity (EGARCH) framework. This approach is used to allow for asymmetric effects of the shocks, allowing both the size and the sign of the shock to have different impacts. The impact of COVID-19 on the transmission mechanism is also explored. The outcomes from this analysis provide strong evidence in support of the “stock-orientated” approach, where significant price and volatility spillovers propagate from the stock market into the foreign exchange market, whilst evidence of the “flow-orientated” approach is seen in the second moment, and significant shock and asymmetric spillovers from the exchange to the stock market are found. The results support the asymmetric and long-range persistence volatility spillover effect and show strong evidence of contagion between stock and foreign exchange markets. These spillovers became more pronounced during the COVID-19 pandemic, confirming heightened contagion in these markets during periods of crisis. Secondly, attention turns to the goods market. The inflation-inflation uncertainty nexus is investigated through GARCH and GARCH-in-mean (GARCH-M) models to establish whether inflation uncertainty is a self-fulfilling prophecy, i.e., does higher inflation uncertainty leads to higher inflation and vice versa? The empirical outcomes from this study suggest the existence of a bidirectional relationship between inflation and inflation uncertainty, with stronger evidence in support of the Friedman-Ball hypothesis which states that heightened levels of inflation induce higher uncertainty about future inflation and weaker evidence in favour of the Cukierman-Meltzer hypothesis that proposes a reverse causation. The study also finds that inflation targeting has contributed significantly to reducing the level of inflation and inflation uncertainty. The Rossi-Wang (2019) time-varying Granger causality testing, which is robust in the presence of instabilities, further provides interesting insight into the relationship  notably that both the Friedman-Ball and Cukierman-Meltzer hypotheses break down during the inflation targeting period, which further hints towards the efficacy of inflation targeting as monetary policy framework. Finally, the thesis determines how high and low states of uncertainty in the three key domestic markets – the stock market, currency market and goods market – and uncertainty in the global market impact the effectiveness of monetary policy in South Africa. High and low uncertainty states in the markets are examined by employing sign-restriction and the Self-Exciting Interacted VAR (SEIVAR) analysis. This framework is particularly appealing in that it allows for estimating the economy’s response conditional on uncertainty states in the different markets. Impulse response analysis reveals that monetary policy is less effective in high uncertainty states in the different markets. Overall, the study attempts to inform policy in the face of uncertainty.