HOW FINANCIAL MARKETS HURT THE REAL ECONOMY: New US evidence

07 Jan 2019

Financial shocks are major drivers of fluctuations in US economic activity, stock prices and investment, but they have had a limited effect on price inflation over the last three decades. That is one of the findings of research by Francesco FurlanettoFrancesco Ravazzolo and Samad Sarferaz, which is published in the January 2019 edition of The Economic Journal.

Their analysis shows how monetary policy based on inflation targeting may be insufficient to preserve macroeconomic stability. Indeed, as experienced during the 2007-2009 crisis, financial shocks can create large boom-and-bust cycles in credit and housing in a context of stable inflation. The study particularly highlights the importance of developments in the housing sector for explaining a substantial share of fluctuations in both credit and economic activity.

The researchers note that the financial sector has long been seen as a propagation mechanism for macroeconomic shocks originating in the real economy or by the monetary policy authority in its attempts to stabilise the economy. But such a role as a mere propagator of shocks does not square well with the narrative of the Great Recession, when the direction of causality seemed to be reversed, going from the financial sector to the real economy.

Important events originating in the housing sector and in credit markets had a large effect on the real economy, suggesting that the financial sector broadly defined may be more a source of shocks with important macroeconomic consequences rather than simply a propagator of shocks.

The new study investigates the importance of shocks originating in the financial sector in the context of an empirical model estimated on US data and identified with a minimum set of assumptions on the sign of economic variables’ responses to shocks. The estimated financial shocks may be related to events like credit liberalisations, financial innovations, relaxations of credit standards, stock market and housing bubbles, housing demand fluctuations and variations in economic uncertainty.

In a first step, the authors study financial shocks jointly with several other macroeconomic shocks – for example, supply, demand and monetary policy shocks – and they quantify their importance for the US economy.

In a second step, the authors disentangle financial shocks into three different components: shocks originating in the housing sector; shocks originating in credit markets; and uncertainty shocks. In the data, housing booms, credit booms and decreases in uncertainty are often correlated: the methodology of this research makes it possible to provide some new results on the direction of causality between these macroeconomic events.

The researchers find that financial shocks are major drivers of fluctuations in US economic activity, stock prices and investment; but they have had a limited effect on price inflation over the last three decades. Financial shocks explain a large part of the output contraction during the 2007-2009 crisis.

Such an important role for financial shocks is able to explain why inflation was low in the pre-Great Recession period and why inflation did not fall much in the aftermath of the Great Recession.

The results indicate that an inflation targeting monetary policy may not be sufficient to preserve macroeconomic stability. Indeed, according to the model, financial shocks may create large boom-and-bust cycles in credit and housing in a context of stable inflation.

When disentangling general financial shocks into housing shocks, credit market shocks and uncertainty shocks, the researchers show that shocks originating in the housing sector play a leading role in business cycle fluctuations relative to the other two shocks. Above all, they have large and persistent effects on economic activity.

The model therefore highlights the importance of developments in the housing sector to explain a substantial share of fluctuations in credit and in economic activity. These housing shocks may have a broad economic interpretation and capture housing preference shocks, bubbles in real estate markets or changes in households’ beliefs about house prices. Alternative interpretations involve productivity dynamics in the construction sector or international factors.

'Identification of Financial Factors in Economic Fluctuations by Francesco Furlanetto, Francesco Ravazzolo and Samad Sarferaz' is published in the January 2019 edition of The Economic Journal.

Francesco Furlanetto

Norges Bank | Francesco.Furlanetto@Norges-Bank.no

Francesco Ravazzolo

Free University of Bozen/Bolzano | Francesco.Ravazzolo@unibz.it

Samad Sarferaz

ETH Zurich | sarferaz@kof.ethz.ch