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.
This is a preview of subscription content, access via your institution.
Buy single article
Instant access to the full article PDF.
Tax calculation will be finalised during checkout.
Subscribe to journal
Immediate online access to all issues from 2019. Subscription will auto renew annually.
Tax calculation will be finalised during checkout.
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.
Andreasen MM, Christensen JHE, Riddell S (2018) The TIPS liquidity premium. Federal Reserve Bank of San Francisco – working paper 2017-11
Christensen J, Gillan J (2012) Do Fed TIPS purchases affect market liquidity? Federal Reserve Bank of San Francisco – economic letter no. 2012-07
Cunningham R, Desroches B, Santor E (2010) Inflation expectations and the conduct of monetary policy: a review of recent evidence and experience. Bank of Canada Review, Spring pp:13–25
D’Amico S, Kim DH, Wei M (2018) Tips from TIPS: the informational content of Treasury inflation-protected security prices. J Financ Quant Anal 53(1):395–436
Fleckenstein M, Longstaff FA, Lustig H (2017) Deflation risk. Rev Financ Stud 30(8):2719–2760
Fleming MJ, Krishnan N (2012) The microstructure of the TIPS market. Federal Reserve Bank of New York – Economic Policy Review 18(1):27–45
Güler MH, Keles G, Polat T (2017) An empirical decomposition of the liquidity premium in breakeven inflation rates. Quarterly Review of Economics and Finance 63(1):185–192
Kim D, Walsh C, Wei M (2019) Tips from TIPS: update and discussion. The Federal Reserve Board of Governors – Fed Notes
Lütkepohl H, Netšunajev A (2018) The relation between monetary policy and the stock market in Europe. DIW Berlin – discussion paper no. 1729
Netšunajev A, Winkelmann L (2014) Inflation expectations spillovers between the United States and euro area. Free University Berlin – SFB 649 discussion paper no. 23
Orlowski LT (2012) Financial crisis and extreme market risks: evidence from Europe. Rev Financ Econ 21(3):120–130
Orlowski LT, Soper C (2019) Market risk and market-implied inflation expectations. International Review of Financial Analysis 66, No. 101389
Putnam BH, Norland E, Arasu KT (2018) Economics gone astray. World Scientific Publishing, Hackensack
Söderlind P (2011) Inflation risk premia and survey evidence on macroeconomic uncertainty. Int J Cent Bank 7(2):113–133
Stillwagon JR (2018) TIPS and the VIX: spillovers from financial panic to breakeven inflation in an automated nonlinear modeling framework. Oxf Bull Econ Stat 80(2):218–235
Strohsal T, Winkelmann L (2015) Assessing the anchoring of inflation expectations. J Int Money Financ 50(1):33–48
Thorbecke W (1997) On the stock market and monetary policy. J Financ 52(2):635–654
Zeng Z (2013) New tips from TIPS: identifying inflation expectations and the risk premia of breakeven inflation. Quarterly Review of Economics and Finance 53(2):125–139
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
About this article
Cite this article
Chomicz-Grabowska, A.M., Orlowski, L.T. Financial market risk and macroeconomic stability variables: dynamic interactions and feedback effects. J Econ Finan 44, 655–669 (2020). https://doi.org/10.1007/s12197-020-09505-9
- Market risk
- Headline inflation
- Breakeven inflation
- Impulse responses
- Markov switching process