Financial markets and the real economy (the production of goods and services) interact. Their movements are highly correlated, and financial indicators can, of course, provide useful information about current economic conditions. They also reflect market participants’ expectations of where the real economy is headed. The question the authors examine is whether financial indicators provide extra predictive power, more so than indicators of the real economy such as surveys of corporate purchasing managers.
“People in financial markets can obtain high returns if they can predict recessions but they are not able to do it—at least not better than anyone else. They cannot anticipate the timing of recessions and they price the risk of one only once they see it,” Professor Reichlin said in an interview with Brookings. “This blindness suggests that information bearing on the economy’s near-term path is rapidly available to all, but rare events such as recessions are fundamentally unforecastable.”
Policymakers should still pay attention to financial variables, even if they offer disappointingly little power to forecast recession risk—and they should seek to limit the accumulation of financial fragilities since those fragilities likely amplify the damage to the real economy once recessions occur, she said.
The authors use econometric techniques to analyze financial data back to 1973 and its ability to predict risks to gross domestic product (the economy’s output of goods and services) in both the very short term (within a quarter) and the medium term (four quarters). They examined both the predictive power of a compilation of financial variables in the United States (the Federal Reserve Bank of Chicago’s National Financial Conditions Index) and individual variables. They also looked at data for 12 other advanced-economy countries and found very similar patterns.
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