Analytical Volatility Is Worse than Market Whiplash

Mohamed A. El-Erian
Mohamed A. El-Erian, President of Queens’ College at the University of Cambridge, is a professor at the Wharton School of the University of Pennsylvania and the author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, 2016) and a co-author (with Gordon Brown, Michael Spence, and Reid Lidow) of Permacrisis: A Plan to Fix a Fractured World (Simon & Schuster, 2023).

CAMBRIDGE – To the extent that financial historians ever refer back to August 2024, I suspect it will be for the craziness of the first three days of the month, when equity prices tumbled as investors’ dumped their darling stocks and sent the VIX (Wall Street’s “fear index”) soaring to levels not seen since the start of the COVID-19 pandemic in 2020. All this disorder will likely be attributed to the “bad technicals” associated with an over-leveraged Japanese yen “carry trade” and junior, inexperienced traders whose superiors were away on summer holidays.

But while the volatility was indeed eye-popping, it did not take long for the damage to be reversed. By the end of August, stocks had more than fully recovered, the VIX was back at its normal levels, and there were indications of traders piling back into the carry trade (borrowing in a low-interest currency to invest in higher-yielding assets elsewhere). Moreover, this recovery was validated and reinforced by US Federal Reserve Chair Jerome Powell’s dovish speech at the Jackson Hole Economic Symposium, where he declared that “the time has come for policy to adjust,” “the direction of travel is clear,” and the Fed does “not seek or welcome further cooling in labor-market conditions.”

As much as these widely covered developments interested me, I will remember August 2024 for different reasons, because I was most struck by the volatility of two other major influences on investors: Wall Street economists’ consensus view of the economy, and their views relating to the Fed’s policy prospects. Here, too, we saw enormous instability, for which junior employees cannot be blamed.

For example, one seasoned, highly respected leader of a strong team of economists at a major Wall Street firm decided, in early August, to increase his group’s recession probability from 15% to 25%. And this dramatic change came just four days after the firm had welcomed Powell’s soothing remarks at the conclusion of the July 30-31 Federal Open Market Committee policy meeting. Equally unusual, the call was partly reversed two weeks later as the firm’s economists lowered their recession probability to 20%, a decision based on a single reading of an inherently volatile weekly data series.

Or consider the economists at another major Wall Street bank who went even further in their early-August reaction. In addition to hiking their recession probability, they declared that the US economy was, in fact, already in recession.

Meanwhile, an equally seasoned, highly respected university professor took to the airwaves to call for a large emergency interest-rate cut before the FOMC’s next regularly scheduled policy meeting in mid-September. He then added that this should be followed by an equally large cut at the time of the meeting.

This degree of analytical volatility is not normal. After all, one generally needs a very solid foundation before making these dramatic calls (or at least to do so with such conviction). What accounts for all the turbulence?

The most charitable interpretation is that the economy could well be at one of those tricky inflection points where data becomes inherently volatile and difficult to assess, and economists are faced with an unusually wide range of plausible scenarios.

A second interpretation relies on the shock value of the August 2, 2024, jobs report, which included an unexpectedly large increase in the unemployment rate. This triggered the Sahm Rule: economist Claudia Sahm’s observation that, historically, such a large upturn in unemployment implies an imminent recession.

A third interpretation is that Wall Street economists have followed the lead of a Fed that has eschewed strategic anchors and become overly dependent on high-frequency data releases, irrespective of their inherent noisiness. Or, more to the point, economists have joined the Fed in treating such data readings – from employment- and price-related data to retail sales and consumer/business sentiment indices – as containing more actionable information than is reasonably warranted.

This tendency is not as irrational as it may sound. If such readings influence how the Fed sees the economy, they will shape policies that will indeed help determine economic outcomes. Still, it is a problem. With Fed and Wall Street economists suffering from extreme data dependency, we should expect the “narrative ping-pong” to continue until one of three things happens.

First, Fed officials could do a better job of re-establishing their strategic anchors. Second, economists could show more willingness to take the significant career risk that comes with “looking through” a central bank (even if it is the world’s most powerful one) that has demonstrated an overly short-term orientation. And third, there could be a big exogenous shock that fundamentally alters the economy’s prospects. If that happens, the data really will call for a new narrative. Until then, look for this historically unusual level of analytical volatility to persist.

Mohamed A. El-Erian, President of Queens’ College at the University of Cambridge, is a professor at the Wharton School of the University of Pennsylvania and the author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, 2016) and a co-author (with Gordon Brown, Michael Spence, and Reid Lidow) of Permacrisis: A Plan to Fix a Fractured World (Simon & Schuster, 2023).