How the VIX (Sort Of) Affects the Fed's Decisions

It sounds funny to suggest the Fed would base decisions off the CBOE Volatility Index (VIX), but that's essentially what it's doing

Sep 22, 2015 at 9:16 AM
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A couple weeks back, former Treasury Secretary Lawrence Summers said that the Fed was unlikely to tighten while the CBOE Volatility Index (VIX) was elevated. On the surface, it sounded kind of silly. I mean, Fed policy dictated by a volatility statistic?

But it sounds more plausible than meets the eye. Volatility, after all, moves generally inverse to the market itself. And, if the market itself has done poorly, the Fed won't tighten. I mean, it literally won't tighten, as per this study:

"[H]ere's the thing: the Fed's decisions are almost entirely dictated by the stock market.

"At least that's the analysis from the global markets research group at Deutsche Bank. Stuart Kirk, a Deutsche managing director, said the 'Fed bashers who say monetary policy is a slave to Wall Street" have a point, showing data to support that claim.' 

" … In over 20 years, the Fed has never hiked once with the market down year-over-year. 'By that logic, forget the dots,' said Kirk, referring to the 'dot plot' graph on which individual Fed members pin their expectations for rates. 'If the S&P 500 is below 1989 come December, expect another hold.'"

What's more, they found that the market tends to rally right before the Fed announcement, so much so that if all you did between 1994 and 2011 was go long for 24 hours into the Fed, you would have realized 80% of the market gains over that stretch. That's ... absurd.

Now, the Fed decision relative to the market does make some sense. No, I don't mean the Fed basing their call on market action. Rather, I mean that, in a way, it's looking at something similar. The stock market is something of a discounting mechanism for future economic growth and trends. So, if the market has acted poorly looking backward, it suggests the economy doesn't look so hot going forward. Or, at least the perception is that the economy won't do well. Of course, we know that's not always the case; the market isn't always the best discounter of information. But, it does represent a prediction going forward.

The Fed is hypothetically doing something similar: It's projecting economic trends going forward and basing policy decisions on those trends. Thus, it is possible that this data really just reflects a logical coincidence, and that it's not really a coincidence, but rather two entities incorporating similar information and reaching similar conclusions. Or "The Fed's just managing and manipulating stock prices!" That's more fun to keep tweeting, and I'm sure someone somewhere is using this data as evidence for that thesis.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research


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