Suppose you had a vote on an interest-rate committee at a central bank. And you were wondering how to figure out what the falls in global stock prices in 2016 meant for your vote.
You might try to reassure yourself by looking at historical correlations between fluctuations in the stock market and variables you were employed to care about, like inflation and resource utilization.
These would be of some use because, although you would be fully conversant with the mantra that the effect of asset prices depends on the ultimate cause of their movements, you may well find yourself, given the imponderables in modern macro and finance, and having invested much energy in trying to decide, little the wiser in determining what exactly caused the global sell off.
And when you spoke to economists and traders close to the market, you’d find that the cacophony was not resolved, but got louder and more confusing still.
Well, here is a reason to be less reassured by those historical correlations than otherwise.
Those correlations will embrace a period in which both monetary and fiscal policy were more free to move to counter the effects of a crash. Now, fiscal policy in the major currency blocs – Japan, ECB, US, UK – is constrained, either by politics, or having tried hard already, or both. And conventional monetary policy is also constrained by the current proximity of the zero [or near to zero] bound. In history, on the assumption that monetary and fiscal policy were counter-cyclical, those correlations between asset prices, inflation and the real economy should have been muted. Going forward, that dampening won’t be there, or at least not to the same extent.
So, although during your deliberations, you might have recounted to fellow committee members the old Samuelson joke that the stock market had forecast 9 out of the last 5 recessions, there is reason, looking ahead, to be more concerned, and expect a smaller fraction of false positives.