Uncertainty spill-overs: when policy and financial realms overlap

TL;DR

This paper investigates how policy and financial uncertainties propagate across countries in Europe, revealing complex spill-over mechanisms and ECB responses using a global VAR model with magnitude restrictions.

Contribution

It introduces an adapted identification approach to distinguish policy from financial uncertainty shocks in a multi-country setting, uncovering new cross-border spill-over and amplification mechanisms.

Findings

Significant cross-border uncertainty spill-overs detected.

Domestic uncertainty shocks are amplified when crossing borders.

ECB reacts more strongly and less persistently to financial uncertainty shocks.

Abstract

No matter its source, financial- or policy-related, uncertainty can feed onto itself, inflicting the real economic sector, altering expectations and behaviours, and leading to identification challenges in empirical applications. The strong intertwining between policy and financial realms prevailing in Europe, and in Euro Area in particular, might complicate the problem and create amplification mechanisms difficult to pin down. To reveal the complex transmission of country-specific uncertainty shocks in a multi-country setting, and to properly account for cross-country interdependencies, we employ a global VAR specification for which we adapt an identification approach based on magnitude restrictions. Once we separate policy uncertainty from financial uncertainty shocks, we find evidence of important cross-border uncertainty spill-overs. We also uncover a new amplification mechanism for domestic uncertainty shocks, whose true nature becomes more blurred once they cross the national boundaries and spill over to other countries. With respect to ECB policy reactions, we reveal stronger but less persistent responses to financial uncertainty shocks compared to policy uncertainty shocks. This points to ECB adopting a more (passive or) accommodative stance towards the former, but a more pro-active stance towards the latter shocks, possibly as an attempt to tame policy uncertainty spill-overs and prevent the fragmentation of the Euro Area financial markets.