Four weeks ago I was in London at a conference organized by one of the biggest U.S. banks. The program included a session with the dread title, “2014, The Death of Volatility?” As it followed a rash of similar presentations and articles this year—“The Strange Death of Volatility,” “The Day Volatility Died” and the like—I knew from experience that a spike in volatility was imminent. And sure enough, since the end of last month, financial markets around the world have gone from gliding up an escalator to riding a bucking bronco.
After trending downward from around 20 two years ago to a low of just above 10 on July 4, the CBOE Volatility Index, commonly referred to as the VIX, leapt above 30 on Oct. 15. At its lowest point, the S&P 500 was down more than 7% since the mid-September peak. Perhaps most alarmingly, long-term interest rates plunged—at one point the yield on the German 10-year Bund fell as low as 0.72%, a truly Japanese number. So much for the death of volatility.
Like “this time is different,” “the death of volatility” is one of those combinations of words that act as a thought suppressant. It first came into circulation, according to Google , in December 2005 and appeared in at least eight published articles, and many more unpublished research notes, in the following two years. Then came financial Armageddon.
Understandably lying dormant for most of 2008 to 2012, the death of volatility then made a huge comeback. In 2013 the phrase appeared in 19 articles; this year in no fewer than 72.
I do not mean to imply that we are again on the brink of disaster. Every month, according to data for U.S. equities going back to 1793, the probability of a greater-than-5% decline in the S&P 500 is roughly 1 in 14. And now, as many commentators were quick to point out—after the fact—we were “due” a correction. Financial markets could hardly ignore indefinitely the disappointing data on growth coming out of Europe and China, or the growing geopolitical risks in the Middle East and the public-health panic about Ebola.
Yet those who make a living by making retrospective causal guesses about what moves financial indexes should beware. For I suspect that the return of volatility has relatively little to do with poor growth data or political turbulence. Instead, it is mainly about monetary policy.
Since 2008, central banks have been conducting a colossal experiment. The federal-funds rate has been at the zero lower bound and the Federal Reserve’s balance sheet has increased by a factor of nearly five, to around $4.5 trillion. The Bank of England has pursued broadly similar policies, though its balance sheet stopped growing at the end of 2012 and is now on a plateau at around £405 billion, five times above its pre-crisis level.
However, central bankers in London as well as Washington have been talking for more than a year about ending their asset purchases and raising interest rates. Next week the Fed is widely expected to announce the end of the third of its programs of “quantitative easing,” QE3. Meanwhile, the most recent “dot plot” published by the Federal Open Market Committee—which depicts where members think the federal-funds rate will be in the future—indicated that only two participants expect it to stay at zero next year, while seven members expect it to be 3% or higher in 2016. That implies significant monetary tightening at a time when growth projections remain stuck in the 2%-3% range and the unemployment rate is falling at least partly because of declining labor-force participation.
A vocal contingent of journalists including Joe Wiesenthal and Josh Barro has declared victory on the Fed’s behalf, arguing for example that falling inflation and the even worse economic performance of the eurozone prove that QE has worked in the U.S. This ignores two things.
First, there is no agreement among economists about how QE works. Since it was implemented, academics have studied its effects on liquidity, the “term-premium” (the difference between the interest on a long-term bond a short-term one) and the exchange rate. The jury is still out.
Second, such an unconventional monetary policy cannot credibly be pronounced a success until it is brought to an end and the financial and economic system returned to normal.
Those of us who worried about inflation back in 2010 clearly jumped the gun. As Nobel laureate Tom Sargent and fellow economist Paolo Surico have argued in the American Economic Review, current policy could lead to inflation only if monetary policy “accedes to persistent movements in money growth by responding too weakly.” Why might that happen? Because, as Carnegie-Mellon economist Marvin Goodfriend pointed out in the Journal of Monetary Economics, current monetary policy has fiscal and distributional consequences that could make it addictive from the point of view of finance ministries and investors.
Even if those temptations are resisted and inflation remains dormant, there remains the bigger problem of financial stability. QE offers a “tradeoff between more stimulus today at the expense of a more challenging and disruptive policy exit in the future,” as the authors of a recent paper, put it. “Stimulus now is not a free lunch, and it comes with a potential for macroeconomic disruptions when the policy is lifted.”
At the annual meeting of the International Monetary Fund in Tokyo in 2012, the Governor of the Reserve Bank of India Raghuram Rajan and I warned that the exit from QE would be much less easy than the Fed was then claiming. Like the “taper tantrum” of summer 2013, this year’s October volatility has shown that there is indeed no smooth way out.
Last week, as last year, it did not take long for the central bankers—led by St. Louis Federal Reserve Bank President James Bullard—to step in. “A logical policy response at this juncture may be to delay the end of the QE,” he said on Oct. 16. “We could react with more QE if we wanted to.” The Bank of England followed suit. Down went volatility. QE . . . D. Next time, call that talk “The Suppression of Volatility.”
Mr. Ferguson is professor of history at Harvard University and the author of “The Great Degeneration: How Institutions Decay and Economies Die” (Penguin, 2013).
