Macroeconomic volatility has declined over the past two decades. Some of this decline appears to have fed through to financial markets in the form of lower risk premiums and higher asset valuations. To some extent, the lack of a clear link between macroeconomic volatility and the level of asset prices in existing research and models should not be a surprise. Explaining asset prices is difficult because they are determined by many complex factors, such as risk aversion, expected future earnings, and expected earnings volatility, which are inherently difficult to measure. A more concrete finding is that the decline in macroeconomic volatility has not led to a decline in asset price volatility. News about corporate earnings appears to have become less volatile, but this factor explains only a small part of the reduction in the volatility of asset prices. 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.

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.

Markets now reflect a fairly positive view about overall economic prospects. Global growth is reasonably strong and broad-based. Underlying inflation is low. Estimates of structural productivity growth in the United States remain high. The global economy has weathered the oil price shock and other recent shocks quite well. Most of the major emerging market economies look stronger than they have in some time. Overall volatility in output and inflation has moderated significantly in the United States and, to a lesser extent, in other economies as well.

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.

In hindsight I'd have to admit the fact we were able in our statements to give some [clue] of where policy was headed has turned out to be helpful...up to this point.  It's helped financial markets and others be prepared for, and adjust smoothly, to what we've done so far...It's probably reduced volatility in financial markets around the time of our policy actions.

My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, Use the right tool for the job.

As you know, the Fed has two broad sets of responsibilities. First, the Fed has a mandate from the Congress to promote a healthy economy--specifically, maximum sustainable employment, stable prices, and moderate long-term interest rates. Second, since its founding the Fed has been entrusted with the responsibility of helping to ensure the stability of the financial system. The Fed likewise has two broad sets of policy tools: It makes monetary policy, which today we think of primarily in terms of the setting of the overnight interest rate, the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight, and a lender-of-last resort function made operational by the Fed's ability to lend through its discount window. By using the right tool for the job, I mean that, as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals--price stability and maximum sustainable employment--while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.