Specifically, during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased--a phenomenon known to economists as the Great Moderation (Bernanke, 2004). This finding challenges some conventional economic views, according to which greater stability of inflation can be achieved only by allowing greater fluctuations in output and employment. The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low even as it retains substantial freedom to respond to disturbances to the broader economy.

At least four possible explanations have been put forth for why the net demand for long-term issues may have increased, lowering the term premium. First, longer-maturity obligations may be more attractive because of more stable inflation, better-anchored inflation expectations, and a reduction in economic volatility more generally. With the benefit of hindsight, we now recognize that an important change occurred in the U.S. economy (and, indeed, in other major industrial economies as well) sometime in the mid-1980s. Since that time, the volatilities of both real GDP growth and inflation have declined significantly, a phenomenon that economists have dubbed the "Great Moderation"...  In that regard, it is interesting to observe that long-term forward rates were also low in the 1950s and 1960s. With long-term inflation expectations apparently anchored at low levels and with the prospect of continued economic stability, market participants may believe that it is appropriate to price bonds for an environment like that which prevailed four or five decades ago.

Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks.

More recently, the evidence has mounted not only that low and stable inflation is beneficial for growth and employment in the long-term but also that it contributes importantly to greater stability of output and employment in the short to medium term. Specifically, during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased--a phenomenon known to economists as the Great Moderation (Bernanke, 2004). This finding challenges some conventional economic views, according to which greater stability of inflation can be achieved only by allowing greater fluctuations in output and employment. The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low even as it retains substantial freedom to respond to disturbances to the broader economy.

Lower inflation has been accompanied by inflation expectations that are not only lower but better anchored, so far as we can tell. Most striking, Greenspan's tenure aligns closely with the Great Moderation, the reduction in economic volatility I mentioned earlier, as well as with a strong revival in U.S. productivity growth--developments that had many sources, no doubt, but that were supported, in my view, by monetary stability. Like Volcker, Greenspan was ahead of academic thinking in recognizing the potential benefits of increased price stability.

Economic theory suggests that the greater liquidity of home equity should allow households to better smooth consumption over time.  This smoothing in turn should reduce the dependence of their spending on current income, which, by limiting the power of conventional multiplier effects, should tend to increase macroeconomic stability and reduce the effects of a given change in the short-term interest rate.  These inferences are supported by some empirical evidence.¹⁰

(I)t is far too early to organize a funeral for the Great Moderation. Even though financial market volatility is exceptionally high and even though the U.S. economy is contracting during the second half of 2008, the demise of the Great Moderation would require much more evidence than currently exists. Real economic variables, in particular, would have to swing much more than they have to date, and the increased volatility would have to continue for a number of years before we could start to compare the current environment to the pre-1984 experience and pronounce the moderation dead.

Interest rates also could potentially have been affected by the Great Moderation. Investors in Treasury bonds require a risk (or term) premium to compensate them for the risk of loss on longer-maturity bonds resulting from movements in interest rates. Term premiums could be lower when inflation expectations are well anchored or the macroeconomy is less volatile.

Now, I would like to explore some of the research that might explain whether and, if so, how the Great Moderation affected the level of asset prices. Structural models of asset prices provide a consistent framework for understanding both equity prices and interest rates. In these models, each asset price contains a risk premium that represents the additional return demanded by risk-averse investors for bearing risk. A reduction in macroeconomic volatility that reduces uncertainty about earnings or dividends could reduce the equity risk premium and, as a result, lead to higher equity prices. Less uncertainty about future inflation could lower the risk premiums on nominal Treasury bonds, lowering the risk-free interest rate. There is, however, a potential offset as well. Lower volatility may reduce the motive for precautionary savings and thus put upward pressure on interest rates and, all else equal, downward pressure on equities.

An effective monetary policy may well have been one factor in the great moderation of inflation and business cycles that I mentioned earlier. And our efforts in recent years to make the policymaking process more transparent may, almost by definition, have reduced uncertainty and thus compressed risk premiums.

Anchored inflation expectations damp the pass-through of supply-related price shocks.  They also permit central banks to respond more forcefully to output fluctuations.  Most significantly, the improved inflation performance has come with, not at the expense of, output stability.  Although a consensus has not formed on how much of the "Great Moderation" in the growth of real output can be attributed to monetary policy, everyone agrees that at least a portion of it can.

The period since the early 1980s was also one of markedly diminished macroeconomic volatility. This change, which has been dubbed the "great moderation," shows up in virtually all aggregate time series for real variables. For example, expansions have been longer and recessions have been shallower and less frequent. This phenomenon has been noted by many authors and the relevant facts were described by Chairman Bernanke in a 2004 speech.

...a variety of other causes have been offered to explain the macroeconomic moderation, including better monetary policy and the good fortune of receiving smaller shocks. Nonetheless, a causal link between the great moderation and the simultaneous wave of financial innovation would seem to be a plausible conjecture.

One of the most significant changes in the U.S. economy over the past quarter century has been the marked reduction in economic volatility. Following the terminology of the Great Depression and the Great Inflation, this period of increased stability has been termed “The Great Moderation.”

The Great Moderation—this period of relatively stable GDP growth—has been accompanied by a lower average level and reduced volatility of long-term interest rates. The more stable financial environment makes it easier for firms and households to plan for the future. The Great Moderation has also made the job of forecasters somewhat easier.

Much of my interest in macro policy has been founded on the belief that it can and should improve the lives of the broad range of our nation's people. I think of this as happening through two channels. First, policies that reduce the frequency and size of the fluctuations in business cycles can spare people the painful disruptions that occur during recessions, or, in the worst cases, tragic events like the Great Depression of the 1930s. Second, policies that succeed in enhancing the long-run growth of productivity should help lift the average standard of living over time.

By many measures, these two channels have been operating extremely well in our economy for some time. In terms of the business cycle, for almost two decades we have been enjoying an era that many economists call the "Great Moderation"; in other words, recessions have been less frequent, and the swings have been less severe, while, at the same time, inflation has come down to quite moderate levels and itself has been less volatile.