Uncertainty is when there is insufficient data, probability distributions are unknown, and statistical analysis must be replaced by intuition and instinct.
Rumsfeld’s risk categorization grid
There are known knowns; there are things we know…there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.
Former U.S. Secretary of Defense Donald Rumsfeld omitted one important case, the unknown knowns. These are boundary values, that are believed to hold with absolute certainty. Sometimes they don’t. Economic models and financial markets do not operate under the same binding structural constraints of physical systems.
These are the truths that aren’t…
The Fed funds rate could never go to zero, or so we believed until 2008. The Fed funds rate has been zero for several years now, and short-term borrowing is effectively free. Unfortunately, what we don’t know is the most vital information if we want to understand what could go wrong.
Monetary policy unknowns
The two scenarios associated with the Federal Reserve’s quantitative easing policy were higher asset prices (good) or rampant inflation and collapsing markets (bad). We experienced the good scenario in 2012 and 2013. The Fed may be initiating a reversal of quantitative easing. Fed chair Yellen has a more challenging task than Bernanke. She must tighten monetary policy such that the outcome is good, given the fact that easing monetary policy had a good outcome.
I realize that macroeconomics is complex, and that a “good” v. “bad” dichotomy is overly simplistic. Has the economy recovered sufficiently, such that it will not react adversely without the Fed’s support?
Usually, economic recovery is indicated by a lower unemployment rate, more housing starts, more projects in commercial real-estate and increased Property, plant and equipment (PP&E) investment by businesses. Without these positive trends, are there any economic conditions or plausible exogenous circumstances that could result in a favorable outcome as Fed bond purchases decrease, tapering to zero?
It’s what you don’t know that matters, according to David Blitzer, Chief Economist at Standard & Poor’s (25 April 2014).