Asset Prices and The Great Moderation

Ben Bernanke's wasn't the only person talking about monetary policy today. There were also two Fed speeches (neither addresses the future course of monetary policy). The first speech by Fed Vice Chair Roger W. Ferguson looks at whether recent declines in GDP and inflation volatility have increased asset values or decreased their volatility and notes that it's hard to find a solid connection between macroeconomic fundamentals and changes in the level or volatility of asset prices. Variation in the discount rate shows up as a much more important factor. The reasons for the Great Moderation and its effects on variables such as asset prices are not settled areas and the speech has quite a few useful references on these topics. The references are included in the continuation frame below:

Asset Price Levels and Volatility: Causes and Implications, by Fed Vice Chairman Roger W. Ferguson: The variability of real activity and inflation in the United States has declined substantially since the mid-1980s--a development often termed the Great Moderation. ... [T]he decline does not appear to be the result of a long-term downward trend but appears to conform more to a structural break around the mid-1980s. The moderation is substantial: The standard deviation of the quarterly growth rate of real gross domestic product from 1985 to 2004 ... is only about one-half its standard deviation from 1960 to 1984. ... A variety of explanations for this Great Moderation have been put forth, ... First, the U.S. economy might have been lucky, ... Another explanation is that firms may have adopted information technologies that allow them to more efficiently manage their inventories ... Better conduct of monetary policy could also lead to lower inflation and economic volatility ... Finally, financial innovations, such as risk-based loan pricing and expanded securitization, may have enhanced the ability of households to borrow, which would make them less sensitive to fluctuations in income... Importantly, equity valuation ... has been higher in the past two decades than in the two decades before that. ... The rise in equity valuations at the same time that macroeconomic volatility fell is circumstantial evidence of a link between the two. ...

Does volatility of real activity affect the level of asset prices? ... [A]lthough the data are suggestive, tests based on asset pricing models have not firmly established an empirical link between reduced macroeconomic volatility and higher asset prices. ... A more concrete finding is that the decline in macroeconomic volatility has not led to a decline in asset price volatility. ... Rather, existing research suggests that asset price volatility remains largely a reflection of variation in investors' discount rates rather than of changes in forecasts of fundamentals. On a micro level, financial innovations and new types of market participants appear to have led to greater market efficiency and liquidity. ...

The second speech is by Governor Olson and discusses the development and unification of the payments system within the U.S. and where it is headed in the future. If you are interested in this topic, there is a lot of useful information and detail in the linked speech:

Perspectives on the Development of a Unified National Payments System in the United States, by Fed Governor Mark W. Olson: ...This morning, I would like to discuss the development of a unified national payments system, or single payments area, in the United States. I will sketch the foundations of the contemporary U.S. payments system and remark on the history of U.S. banking. ... I will then discuss some of the challenges in the U.S. experience, as well as some thoughts on the future of the U.S. payments system. The overarching theme of my remarks is that the United States has evolved toward an increasingly unified national payments system, through both market-driven development and some specific public-sector actions. ...

References from Ferguson Speech:

• Ahmed, S., A. Levin, and B. Wilson, 2004, "Recent U.S. Macroeconomic Stability: Good Policies, Good Practices, or Good Luck?" Review of Economics and Statistics 86 (3), 824-832.
• Bansal, R., and A. Yaron, 2004, "Risks for the Long-Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, 59(4), 1481-1509.
• Bekaert, G., E. Engstrom, and Y. Xing, 2005, "Risk, Uncertainty, and Asset Prices," FEDS Working Paper 2005-40, Board of Governors of the Federal Reserve System.
• Blanchard, O. J., 1993, "Movements in the Equity Premium," Brookings Papers on Economic Activity, 2, 75-138.
• Campbell, J., and J. Cochrane, 1999, "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, 107, 205-251.
• Campbell, S., 2005, "Stock Market Volatility and the Great Moderation," FEDS Working Paper 2005-47, Board of Governors of the Federal Reserve System.
• Clarida, R., J. Gali, and M. Gertler, 2000, "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," Quarterly Journal of Economics, 115(1), 147-180.
• Dynan, K., D. Elmendorf, and D. Sichel, 2005, "Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity?" Journal of Monetary Economics, forthcoming.
• Kahn, J. A., M. M. McConnell, and G. Perez-Quiros, 2002, "On the Causes of the Increased Stability of the U.S. Economy," Federal Reserve Bank of New York, Economic Policy Review, 8 (1), 183-202.
• Kim, C., and C. Nelson (1999), "Has the U.S. Economy Become More Stable? A Bayesian Approach Based on a Markov-Switching Model of the Business Cycle," Review of Economics and Statistics, 81(4), 608-616.
• Kim, D. H., and J. H. Wright (2005), "An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates," FEDS Working Paper 2005-33, Board of Governors of the Federal Reserve System.
• Lettau, M., S. Ludvigson, and J. Wachter, 2005, "The Declining Equity Premium: What Role Does Macroeconomic Risk Play?" paper presented at the Federal Reserve Board conference on Financial Market Risk Premiums: Time Variation and Macroeconomic Links, July 21.
• McConnell, M. M., and G. Perez-Quiros, 2000, "Output Fluctuations in the United States: What Has Changed Since the Early 1980s?" American Economic Review, 90 (5), 1464-1476.
• Pritsker, M., 2005, "Large Investors: Implications for Equilibrium Asset Returns, Shock Absorption, and Liquidity," FEDS Working Paper 2005-36, Board of Governors of the Federal Reserve System.
• Romer, C., and D. Romer, 2002, "The Evolution of Economic Understanding and Postwar Stabilization Policy," (439 KB PDF) in Rethinking Stabilization Policy. Kansas City: Federal Reserve Bank of Kansas City, 11-78.
• Stock, J., and M. Watson, 2002, "Has the Business Cycle Changed and Why?" in M. Gertler and K. Rogoff, eds., NBER Macroeconomics Annual. Cambridge, Mass: National Bureau of Economic Research.