The heightened volatility that has roiled financial markets over the past six months may hamper the U.S. economy if it continues. But analysts dont expect a major effect unless the volatility intensifies.
The increase in volatility since last summer doesnt make me think there is a substantially greater chance of a recession in the U.S. maybe just a little bit, says Jeffrey Frankel, professor of capital formation and growth at Harvard Universitys Kennedy School of Government.
High volatility in financial markets creates uncertainty among consumers and businesses, making them reluctant to spend, economists say.
Volatility began rising when stocks plunged in late August, and after ebbing a bit in the fourth quarter, volatility has come back strong this year. The CBOE Volatility index has stayed above 20 for almost the entire period since January 1. As for stocks themselves, the Standard & Poors 500 index has endured several steep drops of as much as 13 percent since August but each time has rebounded, at least partially. The index stood at 1,948 on Friday, February 26, down about 7 percent from its August high.
Some analysts say the volatility spike has already had a small impact on the economy, helping to restrain growth at 1 percent for the fourth quarter. The stock markets August plunge played a major role in keeping the Federal Reserve from raising interest rates last September, says Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former Fed economist. In addition, falling stocks in January may have led Fed officials to push forward their expectations of the next rate hike, to beyond March, he says.
Gagnon and others say a sustained slide by stocks actually damages the economy more than simple volatility, because it does more to hurt the wealth and confidence of consumers and companies. People overstate how much volatility affects the economy, as opposed to how much the level of stock prices affects it, Gagnon says. An old rule of thumb at the Fed was that consumption will fall by a dollar amount equal to 3 to 5 percent of a sustained decline in stock market capitalization, he says. If volatility is high at the same time stocks are in a rising trend, that would help the economy.
But volatility in the current context does matter, Gagnon and other analysts agree. If it remains at present levels, volatility could take 20 to 40 basis points off U.S. GDP growth this year, says Michael Hanson, senior economist at Bank of America Merrill Lynch in New York. He forecasts an expansion of 2 percent.
The recent volatility has stemmed largely from concern about slow growth, particularly in China; anxiety about falling oil prices; and uncertainty about Federal Reserve policy. But over the past six weeks, fears in the financial markets overran U.S. economic fundamentals, Hanson says.
Economic data for January have shown strength, particularly for employment and inflation. The Atlanta Feds forecast model now puts first-quarter GDP growth at 2.6 percent. A resilient economy should help financial markets, rather than market volatility hurting the economy, Hanson says. But that fear in the market can be self-fulfilling. So there is some risk of volatility getting worse and hurting the economy.
Mohamed El-Erian, chief economic adviser at Munich-based financial services giant Allianz, is worried about that risk. So far the markets have yet to fully reflect the broader signals, including the declining effectiveness of central banks to continue to repress financial volatility, he says. Central banks lack both the will and the ability to do so, in his view.
The volatility reflects a larger problem that particularly besets the central banks, El-Erian says. The seven-year period of slow but steady global growth, fostered by central bank easing that restrained volatility, is coming to an end, he maintains. And its unclear if financial stability and strong economic growth or financial instability and recession will follow. That depends on fiscal policy and structural economic changes like educational and tax reform, El-Erian says.
So whereas market volatility hasnt had a major impact on the economy so far, we cant be complacent about the future, he maintains. This is particularly important if you buy into the notion that this unusual financial volatility ... is part of a multiyear process of economic and policy realignments.