Economic policy uncertainty in the United States has a direct impact on euro area firms’ access to financing, the European Central Bank (ECB) said in a blog post this week, warning that this reduces investment and weakens the effectiveness of monetary policy.
The ECB explained that periods of heightened uncertainty exert significant pressure on economic outcomes.
“They dampen business confidence, delay investment decisions and constrain credit conditions,” the ECB said.
It added that when firms cannot be sure how or when regulations, tariffs or other economic policies might be implemented or changed, they tend to fall into a “wait and see” mode.
While waiting for greater clarity, firms react to heightened uncertainty by postponing investment decisions, while banks contract credit supply to manage potential risks.
The ECB analysis found that increased uncertainty about economic policies, particularly those stemming from trade policy developments in the United States, spill over into the euro area by reducing lending through both loan demand and loan supply.
As a result, high levels of uncertainty make policy rate cuts less effective.
The ECB pointed to the Economic Policy Uncertainty Index, which measures the frequency of use of policy-related terms in major newspapers, noting that it has reached record highs in recent years.
Events such as Brexit, the Covid-19 pandemic and the war in Ukraine each contributed to these surges, while more recent geopolitical risks and uncertainties surrounding United States trade policy have led to peak levels in both the United States and the euro area.
The ECB underlined that financial market volatility has remained low despite this trend.
Historically, episodes of high economic policy uncertainty coincided with more volatile financial markets, but recent data shows a divergence in which economic policy uncertainty spikes while market volatility stays subdued.
“This has prompted us to examine whether policy uncertainty alone, without financial market turbulence, disrupts lending and investment,” the ECB said.
Using a structural Bayesian Vector Autoregression model with aggregate euro area data dating back to 2003, the ECB found that a one standard deviation shock led to a slowdown in loan growth, with effects building over time and peaking at about 0.5 percentage points roughly two years after the initial shock.
The ECB added that the impact of uncertainty is even more severe during episodes of high financial market volatility, when investors demand higher compensation for risk.
This amplifies the negative effect of policy uncertainty, adding about 0.3 percentage points to the contraction in lending.
“These results reinforce the finding that policy uncertainty, especially when coupled with financial stress, can hinder the flow of credit and slow down economic activity just when stimulus is most needed,” the ECB said.
The analysis also found that uncertainty about United States economic policy directly affects euro area banks’ lending behaviour.
Loan-level evidence from the Anacredit database confirmed that higher levels of uncertainty lead euro area banks to reduce credit supply, even after accounting for firm-specific demand and existing lending relationships.
The ECB said that the effect is particularly strong for banks more exposed to the US dollar, which reduce lending to euro area firms by more than less exposed banks.
Such banks also increase interest rates on new loans and shorten maturities, particularly for firms that trade more heavily with the United States.
Other bank characteristics also play a role.
Credit institutions with lower liquidity or higher shares of non-performing loans react more sharply.
The ECB said that a one standard deviation increase in uncertainty reduced loan growth by about one percentage point more for low-liquidity banks compared with higher-liquidity peers, with the divergence persisting for up to two years.
Banks with more non-performing loans experienced a similarly steeper decline in their lending activity in response to uncertainty shocks.
“So, while banks tend to lend less in times of stress, how much less depends on specific bank balance sheet characteristics,” the ECB said.
The ECB stressed that the implications for central banks are significant.
It explained that heightened economic policy uncertainty weakens the transmission of monetary policy.
“During periods of heightened economic policy uncertainty, the effectiveness of monetary policy rate cuts in stimulating the economy declines significantly,” the ECB said.
For investment, the impact of a 100 basis point cut in the short-term rate is about 20 per cent lower, with the effect especially pronounced among investment-intensive firms.
The ECB said that this means central banks may need to respond more forcefully to achieve the same intended impact during periods of high uncertainty.
Looking ahead, the ECB concluded that policy uncertainty can significantly influence credit dynamics, business investment and the effectiveness of monetary policy in the euro area.
“When uncertainty rises, firms tend to delay or scale back investment,” the ECB said.
It added that this is particularly evident among firms operating in sectors more exposed to the United States.
“At the same time, banks – particularly those with high US exposure, limited liquidity or higher levels of non-performing loans – tighten credit conditions. And this reduces lending,” the ECB said.
It warned that policy uncertainty, even when it originates in the United States, can weaken the effectiveness of monetary policy in the euro area.
