Vol 11 (2014) - Issue 4

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Volatility: The Great Moderation, for Now

Has volatility increased since global central banks adopted a zero (or close to zero) interest rate policy? The answer is an emphatic 'No'.
The importance of monetary policy in shaping market expectations

The drop in volatility across a range of assets has been impressive (Exhibits 1-3). The confluence of accommodative monetary policy, modest growth and low inflation plays a role. A change in one of these three drivers will be disruptive and make markets vulnerable to a re-pricing.
Of the three factors mentioned above, central bank action dominates. Volatility has been low for some time excluding the crisis. The clear monetary policy reaction function has played an important role, such as the Taylor rule. Post Great Recession crisis, the Fed's reaction function is Quantitative Easing (QE).
A relatively recent example was the rise in volatility when the Fed stopped its purchases of mortgage-backed securities in 2010. Buying structured products was buying risky assets, or volatility. The timing of ending their purchases in 2010 was premature as the private sector was not ready to 'step in' and provide necessary liquidity for the well-functioning of markets. With no support from the Fed, markets became vulnerable to shocks, e.g., the European sovereign crisis in 2012.
Such market vulnerability forced central banks to rethink their exit strategies and, as we have seen, to adopt additional rounds of QE. The private sector demand for cash remained high, forcing central banks to continue providing liquidity. Swapping cash for riskier assets, or for consumption and investment spending, required central bank assist, i.e., QE.

Preparing for the Exit: Will adjusting to firmer growth bring volatility?
Financial markets tend to be vulnerable to bouts of volatility when (perceived) shifts occur in the policy regime (as per the episode last summer) and/or in the growth trajectory. That is why the Fed and other central banks will probably continue to act in 'measured' steps when exiting QE. As for the pick-up in growth, it will be moderate for at least two reasons, thereby containing volatility:
– The absence of an exogenous demand trigger from the major trading partners.