Federal Reserve Governor Kohn recently discussed how the Fed monitors and interprets risk premiums in financial markets and how that impacts monetary policy. I will present a few highlights, but the entire speech is worthwhile and extracting just a few paragraphs does not do it justice. Those of you interested in the conduct of monetary policy and the factors that go into monetary policy decisions will want to read Governor Kohn's remarks:
Monetary Policy Perspectives on Risk Premiums in Financial Markets, Donald L. Kohn, July 21, 2005 : … I would like to take a few minutes today to broaden the discussion to encompass risk premiums in other markets and to highlight the connections between risk premiums and monetary policy. My goal is … to give you a sense of how estimates of risk premiums may influence our policy decisionmaking ... Among the risk premiums that we monitor regularly at the Federal Reserve are those on equity returns, equity volatility, corporate bonds, and Treasury securities. Each contains information about a different risk around a different expected outcome. … risk premiums are certainly relevant for monetary policy deliberations, and we do pay attention to our best estimates of them. … inferences about future economic conditions obtained from … those premiums. Neglecting or grossly misestimating risk premiums will lead to misperceptions of the market's outlook and thus potentially to market moves that we did not anticipate. Nothing better illustrates the need to properly account for risk premiums than the current interest rate environment: To what extent are long-term interest rates low because investors expect short-term rates to be low in the future due to some underlying softness in aggregate demand, and to what extent do low long rates reflect narrow term premiums, perhaps induced by well-anchored inflation expectations or low macroeconomic volatility? Clearly, the policy implications of these two alternative explanations are very different.
… risk premiums … can also directly affect real economic activity. For example, the decline in term premiums in the Treasury market of late may have contributed to keeping long-term interest rates relatively low and, consequently, may have supported the housing sector and consumer spending more generally. Also, risk premiums may be, in part, a manifestation of investor sentiment, which in turn may be correlated with consumer and business sentiment. … Finally, risk premiums are also important tools for monitoring financial stability. ... Information that bears on investors' attitudes toward risk and on the functioning of financial markets and financial institutions is thus undoubtedly valuable.
… As you can see, we read risk premiums in a variety of ways and for a variety of purposes. … we try first of all to develop a good understanding of the historical behavior of risk premiums.
Click on Figure For Full-Size Version
The top panel of the exhibit … shows crude estimates, put together by the Board's staff, of the risk premium on both equities and corporate bonds going back to 1920. … The configuration of risk premiums in the 1950s presents both similarities and contrasts to the behavior of risk premiums in current times. That earlier decade, like the present, was a time of low interest rates and low inflation, and the corporate bond risk premium was low, just as it is today. But our estimates suggest that the equity premium for that period was substantially higher than it appears to be today. …
The other aspect of the chart that stands out is the apparent decline in risk measures since the late 1970s and early 1980s. … I am intrigued by efforts to separate the extent to which the decline in risk premiums in recent decades is due to a reduction in inflation versus a reduction in real output volatility. In that regard, does the fact that most of the decline occurred by the end of the 1980s suggest that inflation control played a more important role than the damping of business cycles, which might reveal itself more gradually over time?
… Our first challenge is to determine when a movement is not just noise that will quickly reverse, but rather a signal of something important that we need to understand as we formulate policy. … To separate signal from noise, we try to look not only at the persistence of movements but also at their correlation across markets. Is there a widespread increase or decrease in risk aversion or in perceived risk that suggests a shift in underlying attitudes and expectations? If there is, the monetary authority may well need to adjust the stance of policy as the FOMC did in the fall of 1998.
Disparate movements in risk premiums, such as those we witnessed in equity and fixed income markets recently and that are highlighted in the bottom panel of the exhibit, are not unusual and can occur for a number of reasons. … divergences in risk premiums are not necessarily unusual if looked at from a historical perspective. ... But an understanding of what caused the divergent movements could be important for policymakers. … it is important for policymakers to look at risk premiums in their entirety, rather than in isolation, before reaching policy conclusions. … I have mostly characterized policymakers as avid readers of risk perceptions across markets, but our actions could affect risk premiums as well. … our efforts in recent years to make the policymaking process more transparent may, almost by definition, have reduced uncertainty and thus compressed risk premiums. We have emphasized the conditional nature of our discussions of future policy to help market participants calibrate their assessments and price risk.
The question of why volatility has declined is important, but we don’t yet know for sure what factors caused the volatility decline. I suspect it is from real factors such as better information management technology rather than better monetary policy, but the book is still open on this one.