Financial market risk and macroeconomic stability variables: dynamic interactions and feedback effects
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Financial market risk and macroeconomic stability variables: dynamic interactions and feedback effects Agnieszka M. Chomicz-Grabowska 1 & Lucjan T. Orlowski 1 # Academy of Economics and Finance 2020
Abstract This study investigates dynamic interactions and feedback effects between financial market risk proxied by VIX and key macroeconomic stability variables that include the rate of unemployment, headline inflation and market-based inflation expectations reflected by the breakeven inflation. We argue that market risk should play a stronger role in macroeconomic modeling and forecasting than it has been recognized thus far in the literature. We employ vector autoregression with impulse response functions, as well as two-state Markov switching tests to examine these interactions on the longest available US monthly data. The empirical tests show that the association between market risk and macroeconomic fundamentals is predominantly neutral at normal, predictable economic conditions. It becomes very pronounced at times of financial distress, in the environment of elevated market risk coupled with uncertain expectations for macroeconomic variables. Shocks in VIX have a longer impact on macroeconomic stability than that generally claimed in the prior literature. The Markov switching tests for CPI and breakeven inflation indicate that households and businesses are concerned primarily about episodes of increasing inflation, while bond market participants worry mainly about declining inflation and deflation. Keywords Market risk . VIX . Unemployment . Headline inflation . Breakeven inflation .
Impulse responses . Markov switching process JEL classification C54 . E31 . G17
* Lucjan T. Orlowski [email protected]
1
Sacred Heart University, 5151 Park Av., Fairfield, CT 06825, USA
Journal of Economics and Finance
1 Introduction There is a growing attention in the macroeconomic literature to the legitimacy and necessity to incorporate financial risk measures in macroeconomic forecasts, particularly in the aftermath of the recent global financial crisis.1 Inspired by the recent debate pertaining to choices of relevant measures of risk and their impact on macroeconomic variables, we focus on interactions between financial market risk and key macroeconomic policy variables, i.e. unemployment and inflation. Financial market risk is proxied in our exercise by the Chicago Board Options Exchange VIX volatility index based on standard deviation of S&P500 options. We investigate its dynamic interactions with the US civilian unemployment rate and two measures of inflation. We distinguish between a survey based CPI headline inflation and the market-based breakeven inflation (BEI) that reflects inflation expectations of government bond market investors. By using both market-based BEI and survey-based inflation expectations, we take a novel approach that is explored limitedly in the prior literature. BEI has been gradually gaining ground as a viable indicator of inflation expectations for macroeconomic forecasts since it refl
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