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.

We need to produce a substantial reduction in our structural deficit over the medium term and begin to reduce the more dramatic longer term gap between our resources and commitments. And we need to restore a reasonable cushion in our structural budget balance to help us deal with future shocks.  If we are unable to begin to generate more confidence in the capacity of the U.S. political system to produce these improvements, we would face a greater risk of future increases in risk premia.

Some have asserted that our accommodative policy stance in recent years, made necessary by the macroeconomic situation, itself has tended to drive down risk premiums as investors "reached for yield." Notably, however, most risk spreads have remained narrow even as we have been removing policy accommodation.

Risk premiums are certainly relevant for monetary policy deliberations, and we do pay attention to our best estimates of them…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…We are also interested in risk premiums as indicators of uncertainty and not solely as inputs into accurate readings of investors' mean economic outlook.

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.

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?

Some, but not all, of the decade-long trend decline in that forward [bond] yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades.

So, how much of the enlargement of the U.S. current account deficit can we attribute to improved international intermediation? This is difficult to answer because it is hard enough to measure a concept as amorphous as international financial intermediation, let alone to gauge its effect on the current account. As a step in this direction, however, we reasoned that any reduction in home bias by foreign investors toward the United States would show up as a decline in the risk premium these investors demand for holding U.S. assets. This decline in the risk premium, in turn, would lead to a greater demand for U.S. assets and a rise in the dollar.

Based on an estimate of the decline in the risk premium that occurred since the mid-1990s, our macroeconomic model suggests that the decline contributed importantly to the rise in the dollar, and, therefore, to the widening of the trade deficit. Assuming that the lower risk premium can be attributed to growing international intermediation, this latter development apparently exerted an important influence on the U.S. current account.

Together, however, these imbalances [in the federal budget and current account] raise the potential for higher risk premia on U.S. financial assets and more uncertainty about future returns on claims on the United States. This in turn could reduce expected future investment, productivity growth and U.S. growth potential. This could reduce the willingness of the world’s savers to put their capital to work in the United States. And this could mean lower growth outcomes and slower growth in future incomes.

This mix of challenges in our fiscal and external positions deserve concern and attention. They may end up being diffused gradually and benignly, but they necessarily bring with them a greater risk of higher risk premia, a more adverse investment environment and poorer growth outcomes. Under some circumstances, this could undermine an important foundation of the environment for innovation that has delivered our productivity acceleration.

These favorable fundamentals are reflected in low risk premia of many forms -- low credit spreads, low and quite stable inflation expectations, and low actual and implied volatility. Market participants appear to believe that future macroeconomic shocks will be more moderate, less frequent, and less damaging than past shocks have been. To say this another way, the price of insurance against a less benign world is now quite low.

If the monetary authority can be clearer about what it is doing now and what it plans to do--not in the sense of setting future moves in stone, but rather in terms of explaining risks that might influence future policy--then market participants can improve their expectations of future short rates. Also, less uncertainty about monetary policy might reduce the premium for uncertainty. Thus, transparency ought to bring the rates that matter most for the macroeconomy into closer alignment with the intentions of monetary policymakers. In effect, greater transparency allows policymakers to work with the market, not against it.

All the new financial products that have been created in recent years contribute economic value by unbundling risks and reallocating them in a highly calibrated manner. The rising share of finance in the business output of the United States and other countries is a measure of the economic value added by the ability of these new instruments and techniques to enhance the process of wealth creation.

...This redistribution of risk induces more investment in real assets, presumably engendering a higher standard of living. This occurs because financial intermediation facilitates diversification of risk and its redistribution among people with different attitudes toward risk. Any mechanism that shifts risk from those who choose to withdraw from it to those more willing to take it on increases investment without significantly raising the perceived degree of discomfort from risk borne by the public.

During a financial crisis, risk aversion rises dramatically, and deliberate trading strategies are replaced by rising fear-induced disengagement from market activity. It is the general human experience that when confronted with uncertainty, whether in financial markets or in any other aspect of life, disengagement is the normal protective reaction. In markets that are net long, the most general case, disengagement brings falling prices. In the more extreme manifestation, the inability or unwillingness to differentiate among degrees of risk drives trading strategies to seek ever-more-liquid instruments that presumably would permit investors immediately to reverse decisions at minimum cost should that be required. As a consequence, even among riskless assets, such as U.S. Treasury securities, liquidity premiums rise sharply as investors seek the heavily traded "on-the-run" issues--a behavior that was so evident in the fall of 1998.

[A] decline in uncertainty resulting from a substantial increase in real-time information implies a reduction in what might be called "knowledge float"--the ability to maintain proprietary information and earn a rate of return from that information with no cost. As you know, financial intermediaries historically have been successful not only because they diversified to manage risk but also because they possessed information that others did not have. This asymmetry of information was capitalized at a fairly significant rate. But that advantage now is rapidly dissipating. We are going to real-time systems, not only with transactions but with knowledge as well.