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Wall Street Used to Crunch Numbers. They’ve Moved On to Stories

Bloomberg logoBloomberg 9/16/2019 Craig Torres

Robert J. Shiller wearing a suit and tie: For `Inflation Guy' (and Shiller), Medical TIPS Are `Holy Grail'© Bloomberg For `Inflation Guy' (and Shiller), Medical TIPS Are `Holy Grail' U.S. business may have been talking itself into a slowdown.

That’s one way of reading a study by the Carlyle Group, using techniques from narrative economics –- an emerging field set to gain momentum with the publication of Nobel prize-winner Robert Shiller’s much-anticipated book on the topic.

The Carlyle researchers wanted to know what stories people –- in this case, corporate executives –- were telling others, and maybe themselves, about the economy. So they used algorithms to search hundreds of earnings calls, as well as conversations with the 277 firms in Carlyle’s portfolio. And they spotted a sharp rise in use of the term “late-cycle’’ at the end of 2018 and into the first six months of this year.

a screenshot of a cell phone: It's Getting Late© Bloomberg It's Getting Late

“There was no external objective reality that we could look at then to say, ‘we are late-cycle’,” says Jason Thomas, Carlyle’s director of research. But “there was clearly something in the water,’’ he says -– driven by the calendar, which showed the U.S. economy’s expansion was about to become the longest ever. And, right on cue, “we’ve seen a deceleration in capital expenditure.’’

‘Watch the Narratives’

Some of that slowdown was likely induced by trade-related tensions, though most of the study covered the period before President Donald Trump stepped up hostilities with China in the middle of this year.

The researchers were looking for something beyond the numbers, spurred by the idea that beliefs can shape what people do -- and narratives shape beliefs.

In the recent history of economics, rational expectations theory treated people as though they were some kind of calculator, while behavioral economics tried to dig deeper into the psychology of decision-making. Narrative economics goes a step further -- asking how social media networks like Twitter, Trump’s favorite megaphone, are turbo-charging the spread of stories, and their impact on how people act.

For investors, these stories offer new data to mine. Shiller says it’s a vital area for academic study too.

“To best predict economic activity, we need, among other things, to watch the narratives,’’ he said in his 2017 American Economic Association presidential address.

Central bankers can’t just watch. They need to promote their own narratives, too –- and it’s getting harder.

Former Fed Chairman Alan Greenspan’s pronouncements were seen as the most authoritative story around. Markets hung on his words, while Congress invited him to testify on everything from world demography to energy policy. But something happened to central-bank credibility in the financial crisis. The public and lawmakers became more skeptical of their ability to see ahead.

At the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming last month, central bankers discussed the new roles they have to play.

“I’m a shaman,” said Stefan Ingves, governor of Sweden’s Riksbank. “I’m a weatherman, I’m a showman, and I’m an economist.’’ But above all: “I’m expected to be, and I am, a storyteller. I tell stories about the future.”

“And if I’m successful in my storytelling,” he added, “people say: ‘Hmm, that’s reasonable.’’’

Many central banks -- aside from the Bank of Jamaica, which promotes its inflation target with reggae music -- are old-school when it comes to communications. That includes the Fed, which is expected to deliver a second-straight cut of 25 basis points to its benchmark interest rate this week.

Message Received?

Fed Chairman Jerome Powell stands at a podium during press conferences, with pieces of paper for reference and no illustrative media, except for forecasts that are handed out four times a year. When he’s done, markets parse his words -– typically seizing on one or two catchphrases –- and then run off with their own narrative about what they mean.

The central banks don’t always do a good job of tracking how their message is received in real-time. But that’s exactly what sophisticated investors are doing, says Pedro Domingos, an expert in machine-driven linguistic processing who leads a research unit at hedge fund D.E. Shaw.

Artificial intelligence can take the “maelstrom of information on social media” and turn it into something quantitative, says Domingos. He says central banks need to get deeper into the storytelling game, because “you can’t bring a knife to a gunfight.”

A case in point was the Fed’s plan to trim the bond portfolio it accumulated during and after the financial crisis.

The operation, known as balance-sheet runoff, was announced in June 2017. The Fed decided that the shrinkage wouldn’t exceed $50 billion a month, and said it would be a background process with little visible impact -- “like watching paint dry,” former Chair Janet Yellen said.

Coup de Message

It was hard for economists to quantify the effects on economic growth, or longer-run interest rates. But that didn’t matter. This battle was going to be won or lost on narrative grounds.

By mid-2018, stock commentators began to cite “quantitative tightening’’ as the market’s main nemesis.

As stocks sold off after the Fed’s rate increase on Dec. 19, Powell said at his press conference that the Fed didn’t see the runoff “creating significant problems.’’ Everyone from Trump -- who urged the Fed to “stop the 50 Bs’’ -- to economists and investors seemed to disagree. And just two days later, New York Fed President John Williams began to shift the story, indicating the Fed would be flexible in its approach.

The lesson is that even a highly credible institution like the Fed can be vulnerable to a coup de message.

“Emerging narratives determine expectations,” says Domingos. “And expectations determine everything else.’’

Watch Them Spread

That may be critical in the U.S. now. Unemployment is low, and forecasters expect the economy to keep growing for at least the next two years. Yet more people are asking their favorite crystal balls –- whether it’s Google or the Treasury yield curve –- if a recession is likely.

Thomas, the Carlyle Group economist, says narratives are “mimetic.’’ Once somebody starts making a statement, or asking a question, it gets repeated . Computers can watch the process unfold on social media. -- and even track who the first movers are.

Shiller has compared the process to an epidemic. “We need to incorporate the contagion of narratives into economic theory,’’ he writes in the new book’s preface. “Otherwise, we remain blind to a very real, very palpable, very important mechanism for economic change.’’

--With assistance from Rich Miller.

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