Confidence and investment

Prepared by Malin Andersson and Benjamin Mosk

Published as part of the ECB Economic Bulletin, Issue 4/2019.

Economic agents’ confidence and developments in the real economy are intrinsically linked.^[1] Periods of high confidence could, per se, spur activity, while currently lower confidence could reinforce the magnitude and persistence of the ongoing economic slowdown in the euro area. In terms of the expenditure components of GDP, business investment is particularly affected by changes in confidence and uncertainty, as firms may postpone their investment plans and choose to “wait and see” in times of high uncertainty.^[2] This box looks at the potential propagation effects of lower confidence on investment in recent times.

Following an extended period of improving sentiment, economic confidence in the euro area has worsened since the end of 2017. The deterioration in sentiment is not just a result of expectations of weaker economic fundamentals, but also reflects heightened uncertainty related to geopolitical factors, the threat of an escalation of protectionism, Brexit and vulnerabilities in emerging markets, including China. Confidence is illustrated, inter alia, by indicators such as the European Commission’s Economic Sentiment Indicator (ESI). The ESI is a composite indicator measuring confidence in the industrial, services, construction and retail trade sectors, and among consumers.^[3] Since the end of 2017 the ESI has declined significantly in the larger euro area countries and in the euro area as a whole, although it remains above its long-term average value of 100 (see Chart A). The decline in confidence in the euro area is common across sectors (see Chart B).

Confidence largely reflects broad economic conditions but, at times, it may also become an autonomous source of business cycle fluctuations. Confidence indicators typically co-move with other economic statistics, as they represent expectations of underlying macroeconomic fundamentals. At the same time, those indicators might provide additional information not captured by other statistics, which can be used to assess macroeconomic developments.^[4] As an illustration, confidence may decline during a sharp economic downturn, but this may still correspond to a positive confidence shock if the underlying economic conditions justify an even lower confidence level. Such confidence shocks might be instrumental in supporting expert judgement in order to complement model-based projections.

Model evidence suggests that confidence shocks have had an overall positive impact on investment growth in the past two years and a negative impact in 2019. The New Multi-Country Model (NMCM),^[5] the ECB’s main model for macroeconomic projections,^[6] does not explicitly feature confidence but can be augmented with a mechanism to quantify the impact of structural confidence shocks. Confidence is introduced in the model in two steps. First, confidence shocks are identified using a structural vector autoregression model that includes the variables of the NMCM’s investment equation.^[7] In the second step, those confidence shocks are introduced in the NMCM. The model residuals for the investment equation, which capture the difference between the model’s output and economic outcomes, can partially be explained by the confidence shocks.^[8], ^[9] Based on these empirical results, the model is used to decompose historical investment growth into a confidence factor and other factors, which shows that investment growth was, overall, significantly and positively impacted by confidence in 2017 and 2018 (see Chart C). This analysis can be extended to the forecast after making assumptions about future confidence indicators and interpreting the Eurosystem staff forecast data through the lens of the NMCM.^[10] Assuming that the euro area ESI remains at its May 2019 level, model simulations point towards a negative but modest contribution of confidence to investment growth in 2019, partially counteracting factors that support the euro area expansion, such as favourable financing conditions, further employment gains and rising wages, and the ongoing – albeit somewhat slower – expansion in global activity.

_{To conclude, the quantitative exercise shows that confidence shocks could have a sizeable impact on investment.}