Where do financial markets end and the “real economy” begin?

Where do financial markets end and the “real economy” begin?

It can be easy to confuse the financial sphere with the “real” economy of employment, growth, and macroeconomics. But while movements in the market can be independent of the economy, the two are still intricately connected. The question facing policymakers is: how are they connected, and when does one spill into the other?

The US Federal Reserve is extremely unusual in the world of central banks in 2015: unlike the more than 25 central banks that have cut rates or otherwise loosened policy, the Fed is in the early stages of a tightening cycle (considering it has already wound down its quantitative easing program).

The last two months of upheavals in global financial markets have thrown a wrench in Fed Chair Janet Yellen’s plans to end the accommodative monetary policy of the last eight years. Between this and the memory of the central banks’ active role in the 2008 financial crisis, it is understandable to believe that the real economy and financial sphere are one and the same.

But in reality, they are two separate entities. They do, however, react to each other in complex ways and, crucially, do so during extreme events and volatility.

Market movements not always indicative of economic fundamentals

Given the interconnectedness of the financial system and the rest of the economy, drawing strong distinctions between financial markets and the ‘real’ economy is tricky. But understanding the different driving forces behind the two is important for understanding central banks’ decision-making.

The crucial difference between markets and the so-called ‘real’ economy is the role of valuation and expectations. For example, when markets overheat and valuations become stretched, they quickly contract and usually overshoot. Likewise, valuations are conditioned on the flow of future profits, which rely on forecasts.

When companies miss those estimates, the value of investments in those securities plummet—and may do so in seemingly erratic ways. When central banks look at the health of the economy, they do not fall into the same expectations feedback loop, which is seen in how much more volatile financial markets (purple and red) are than economic indicators (blue and green) in the graph below.

Prices of financial assets are much more volatile than economic indicators, which is why central banks try not to take them into account outside of extreme events. Source: Federal Reserve Economic Data

This is why the run-up and subsequent crash of the Chinese stock market was not at first a major concern for the Fed. Only after it became clear that the Chinese economy was slowing down did it become a focus. Now, the impact on trade, currencies, and commodities globally has begun seeping into core macroeconomic indicators.

The last several months have shown how the two are connected

At the best of times, financial markets are simply a quiet intermediary in the economy—a crucial part, but one with its own independent idiosyncrasies. But because of its central role in allocating capital between savers and spenders, when markets catch a cold, the rest of the economy can get it, too. This is the ‘2008 financial crisis explanation.’

In reality, policy implications for this ‘contagion connection’ have been a relatively small factor in interest rate decisions. Although the Fed takes into account financial stability, and have had members express concerns for how low rates affect the financial sector, the policy changes in this area have focused on broader regulatory changes like ending Too-Big-To-Fail banks and changing capital requirements on risky banking activities.

Beyond that, there is the current situation of the US, which is a key contributor to why the Fed did not raise rates at its September meeting; A shock in the form of slowing global trade has had negative effects on both the ‘real’ economy and financial markets.

US markets ended the summer on a downslide of record volatility given fear about how a slowdown in China would affect the US. Similarly, the Fed pointed to an uncertain global economy as a cause for concern. These global uncertainties would begin to affect the ‘real’ US economy through shrinking exports and further gains in the US dollar, which only exacerbates the pain in exports.

Whether the volatility and uncertainty leads US and British consumers to rein in spending this holiday season provides another worry, though the deteriorating ‘consumer sentiment’ of the past several months has not actually translated into significantly weaker consumer spending.

With this in mind, how will the Fed set policy rates in the coming months? Several FOMC members have expressed interest in raising rates and normalizing their policy soon. But even if US markets end the year in the red, the Fed is extremely unlikely to alter their policy path unless markets move violently lower.

As for ‘real’ economic considerations, the September jobs report was disappointing. If the October report echoes it, there is a real risk that the first rate hike will be delayed into 2016, especially with inflation so low.

Categories: Finance, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.