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.
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In consistency with Fleckenstein et al. (2017), Andreasen et al. (2018) and D’Amico et al. (2018), we recognize that BEI does not only reflect real-time inflation expectations. It also contains a liquidity premium of TIPS. They all provide evidence that the liquidity premium of TIPS is sizeable and countercyclical, as investors anticipating economic recovery and higher inflation buy and hold TIPS reducing their availability for trading. Because of their weaker market liquidity, the prices of TIPS are then penalized with a discount known as a liquidity premium that reflects the present value of expected future trading costs as well as compensation for being forced to sell the bond at a discount. Such forced selling increases TIPS yields and complicates inflation expectations inferred from BEI.
The Augmented Dickey Fuller unit root tests indicate stationarity of all tested variables at their levels, except for the CPI inflation. The estimated ADF τ-statistics are: −4.27 for VIX, −2.98 for the unemployment rate, −2.84 for CPI year-on-year inflation rate, −4.04 for 5-year BEI and − 3.94 for 10-year BEI. The McKinnon critical values at 5% are between −2.87 and − 2.88 for the examined sample periods.
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Chomicz-Grabowska, A.M., Orlowski, L.T. Financial market risk and macroeconomic stability variables: dynamic interactions and feedback effects. J Econ Finan (2020). https://doi.org/10.1007/s12197-020-09505-9
- Market risk
- Headline inflation
- Breakeven inflation
- Impulse responses
- Markov switching process