Press release - Does financial market volatility influence the real economy?
After a quiet period on the financial markets in 2017, there was eventually a resurgence of volatility in February and again more recently in October and November 2018. Many financial analysts say that these sudden surges could be connected with changing expectations about the pace of normalisation of American monetary policy, and typically coincide with the publication of inflation and employment figures. The financial markets react to the publication of macroeconomic data, and that is particularly true in the present context of an international trade war and geopolitical tensions. In all probability, there could therefore be further spikes in volatility due to specific events or announcements.
In general, and often rightly, high financial market volatility is associated with stock market crashes, or even economic recessions. Various episodes come to mind, such as the latest financial crisis, the bursting of the dot.com bubble, the Great Depression triggered in 1929, and many others. In principle, high market volatility reflects an increased risk for investment, thus hampering decisions by market players. It could also have repercussions beyond the financial sector, for example if a volatility risk premium adds to the cost of issuing company shares. High or increasing volatility is therefore generally seen as a negative signal from the financial markets regarding the outlook for the real economy.
And yet … The historical link between market volatility and economic crises reveals that it tends to be prolonged periods of low volatility that presage systemic financial crises. Periods of low volatility seem to nurture a degree of optimism among economic agents and encourage them to take more risks. Among other things, that optimism and increased risk taking may result in a financial bubble and a credit surplus in the economy. Accordingly, recessions preceded by a period of low volatility combined with a stock market bubble are more serious and protracted than other recessions.
In the current situation, while it seems prudent to consider that the low volatility environment may still be relevant, since the sudden surge in volatility in October and November might not persist, it is necessary to keep a close eye on financial asset prices and credit developments to the extent that they indicate a potential accumulation of systemic risks.
More generally, macroprudential policy has a role to play where the optimism prevailing during periods of low volatility reflects a “this-time-is-different” syndrome. According to Reinhart and Rogoff (2009), “financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy.” (p. xxxiv). The trap due to this way of thinking seems perfectly applicable to periods of low volatility. During these periods, the financial markets appear calm, while credit expands steadily and facilitates the funding of investment that promotes economic growth. However, the systemic risks may accumulate and ultimately lead to a crisis. It is therefore during these periods of apparent calm that countercyclical macroprudential policy can take action. Its aim may be twofold: to build up reserves that can be used during crises, and possibly to slow the build-up of risks if they can be identified sufficiently clearly. If macroprudential policy were to succeed in doing that, it could limit the chances of a systemic financial crisis or mitigate its impact.