Financial market risk and macroeconomic stability variables: dynamic interactions and feedback effects

Agnieszka M. Chomicz-Grabowska and Lucjan Orlowski
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Agnieszka M. Chomicz-Grabowska: Sacred Heart University

Journal of Economics and Finance, 2020, vol. 44, issue 4, No 2, 655-669

Abstract: 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 (search for similar items in EconPapers)
JEL-codes: C54 E31 G17 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (1)

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DOI: 10.1007/s12197-020-09505-9

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