Risk, Uncertainty and Monetary Policy

Abstract

In 2013 all ECB publications feature a motif taken from the €5 banknote.note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. ABSTRACTThe VIX, the stock market option-based implied volatility, strongly co-moves with measures of the monetary policy stance. When decomposing the VIX into two components, a proxy for risk aversion and expected stock market volatility ("uncertainty"), we find that a lax monetary policy decreases both risk aversion and uncertainty, with the former effect being stronger. The result holds in a structural vector autoregressive framework, controlling for business cycle movements and using a variety of identification schemes for the vector autoregression in general and monetary policy shocks in particular. The effect of monetary policy on risk aversion is also apparent in regressions using high frequency data. JEL Codes:E44, E52, G12, G20, E32 Keywords:Monetary policy, option implied volatility, risk aversion, uncertainty, business cycle 2 NON-TECHNICAL SUMMARYA popular indicator of risk aversion in financial markets, the VIX index, strongly co-moves with measures of the monetary policy stance in the United States. While the current VIX is positively associated with future (real) Fed funds rates, the relationship turns negative and significant after 13 months: high VIX readings are correlated with expansionary monetary policy in the mediumrun future (see Figure 1).The strong interaction between the VIX index, known as a "fear index" (Whaley (2000) (2005) ascribe the bulk of the effect to easier monetary policy lowering risk premiums, reflecting both a reduction in economic and financial volatility and an increase in the capacity of financial investors to bear risk. By using the VIX and its two components, we test the effect of monetary policy on stock market risk, but also provide more precise information on the exact channel.This article characterizes the dynamic links between risk aversion, uncertainty and monetary policy in a structural vector autoregressive (VAR) framework. Our VARs always include a business cycle indicator to control for business cycle movements. The main findings are as 3 follows. A lax monetary policy decreases risk aversion in the stock market after about nine months. This effect is persistent, lasting for more than two years. Moreover, monetary policy shocks account for a significant proportion of the variance of the risk aversion proxy. Monetary policy shocks have a significant impact on risk aversion also in regressions using high frequency data. The effects of monetary policy on uncertainty are similar but somewhat weaker.On the other hand, periods of both high uncertainty and high risk aversion are followed by a looser monetary policy stance but these results are less robust and weaker statistically. Finally, it is the uncertainty component of the VIX that has the statistically stronger effect on the business cyc...

Measuring Uncertainty

“…While these analyses are sensible starting places and important cases to understand, we emphasize here that the measures of dispersion and stock market volatility studied may or may not be tightly linked to true economic uncertainty. Indeed, one of the most popular proxies for uncertainty is closely related to …nancial market volatility as measured by the VIX, which has a large component that appears driven by factors associated with time-varying risk-aversion rather than economic uncertainty (Bekaert, Hoerova, and Duca (2012)). A separate strand of the literature focuses on cross-sectional dispersion in N A analysts'or …rms'subjective expectations as a measure of uncertainty:…”