The Economy by Peter R. Crabb: Fed's intervention adds to uncertainty

PETER R. CRABB, professor of finance and economics at Northwest Nazarene University in NampaJune 18, 2013 

Peter Crabb

Speaking about the Great Depression and its effect on citizen morale, President Franklin D. Roosevelt said, "The only thing we have to fear is fear itself." Today, the Federal Reserve is creating fear in the markets.

Financial market risk, or uncertainty, is measured using prices on option contracts. The most famous index of these prices is the Chicago Board Options Exchange's Market Volatility index, or VIX. This so-called fear index comprises stock option prices for the large U.S.-based companies in the Standard and Poor's 500 Index.

The VIX reflects the cost of hedging risk through the sale or purchase of option contracts on the stocks of U.S. companies. Option prices rise when the underlying stock prices move dramatically in one direction or another - reflecting greater uncertainty over the future stock price.

At the start of this year, the VIX index was at 13.8 percent, quite low compared with its long-term average of around 20 percent since 2004. The 6 percent difference may not seem like much but actually reflects are large change in risk.

The percent value of the VIX index is a statistical measure called standard deviation. A VIX value of 20 means that we should expect to see stock investment returns deviate from their long run average return of around 10 percent by about 20 percent on an annualized basis.

In terms of probability, a 20 percent standard deviation means there is about a 1-in-3 chance investors will lose money over the course of any given year. In contrast, a 14 percent standard deviation, like that at which we started the year, corresponds to a less than a 1-in-4 chance of loss.

Stocks started off the year looking less risky than average, but even risk itself is becoming harder to gauge. Since the start of May the VIX index has bounced around from a low of 12.55 percent to a high of 17.5 percent. This 5 percent range for expected risk equates to a large difference in the chance of negative returns.

Increased volatility and changes in risk assessments are also found in other financial markets. The CBOE Gold Volatility Index started off the year like stocks at 13.4 percent but jumped to 30 percent in mid-April and has now leveled off around 23 percent.

The only thing certain about the markets these days is the uncertain outlook for economic growth and government policy. As reported by The Wall Street Journal earlier this month, many financial market participants say we had a "placid" start to the year and are now warning investors to expect sudden changes in prices over the next few months. The report goes on to say that volatility is up because economic indicators like consumer spending and hiring are giving mixed signals about growth, and no one is sure when the Federal Reserve will end its bond-buying spree.

The two issues are related. The indicators are inconclusive on the state of the U.S. economy because the Fed is too involved in the markets. The Fed now owns nearly $1.9 trillion in U.S. Treasury debt, four times what it owned at the beginning of 2009 and 16 percent of the total. The Fed also has about $1.2 trillion in mortgage-backed securities and has said it will continue buying more.

The Fed has spent more than $3 trillion trying to speed up economic growth, but as a consequence it is distorting perhaps the most important financial market signal - interest rates. The financial crisis is over, and the economy is growing, so interest rates should be rising. The Fed has kept rates artificially low for too long, confusing bankers, businesses and buyers of all types.

Fear itself is here to stay. If the Fed keeps its powerful hands in the market, investors should continue to expect the unexpected. Volatility and uncertainty will abound.

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prcrabb@nnu.edu

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