For release on delivery
5:30 a.m. EST (11:30 a.m. local time)
November 12, 2019
Monetary Policy, Price Stability, and Equilibrium Bond Yields:
Success and Consequences
Remarks by
Richard H. Clarida
Vice Chair
Board of Governors of the Federal Reserve System
at the
High-Level Conference on Global Risk, Uncertainty, and Volatility, cosponsored by the
Bank for International Settlements,
the Board of Governors of the Federal Reserve System,
and the Swiss National Bank
Zurich, Switzerland
November 12, 2019
Good morning. I am honored and delighted to participate in this second annual
conference on global risk, uncertainty, and volatility, cosponsored by the Federal Reserve
Board, the Bank for International Settlements, and the Swiss National Bank.1 I would
like especially to thank the Swiss National Bank for hosting this event. This conference
is part of continuing work across all of our institutions and the academic community to
better quantify and assess the implications of risk and uncertainty. I am pleased that this
year the focus of the conference is on two of my long-standing professional interests-
financial markets and monetary policy. And my remarks today will not stray far from
those interests. In particular, I would like to address an issue that has been much in
focus-the decline in long-term interest rates-highlighting the role of monetary policy
in contributing to that decline and the implications of that decline for the conduct of
monetary policy.
The Decline in Long-Term Interest Rates and the Role of Monetary Policy
One of the most remarkable and fundamental changes in the global financial
landscape over the past three decades has been the steady and significant decline in
global sovereign bond yields. From the late 1980s, when 10-year nominal Treasury
yields in the United States and sovereign rates in many other major advanced economies
were around 10 percent, global bond yields in the advanced economies have trended
lower to levels below 2 percent today (figure 1, "Bond Yields").
To understand and interpret this decline, it is useful to think of the yield on a
nominal 10-year bond as the sum of two components: investors' expectation over the
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next 10 years of the average level of short-term interest rates plus a term premium. The
term premium is the additional compensation-relative to investing in and rolling over
short-maturity bills-that bondholders require for assuming the risk of holding a long-
duration asset with greater exposure to interest rate and inflation volatility. Importantly,
according to economic theory the equilibrium term premium can be negative. In this
case, which is relevant today in the United States and some other countries, the exposure
to interest rate and inflation volatility embedded in a long-maturity bond is more than
offset by the potential value of the bond in hedging other risks, such as equity risk.2 The
expectation of the average level of future short-term interest rates can, in turn, be
decomposed into the expectation of average future real interest rates and the expectation
of average future inflation rates. Performing this standard decomposition reveals that the
decline in long-term rates reflects declines in all three components: expected real rates,
expected inflation, and the term premium (figure 2, "Yield Decomposition"). I will now
discuss each of these components in turn.
With respect to expected real short-term interest rates, one reason investors expect
lower future short-term interest rates is that neutral interest rates appear to have declined
worldwide and are expected to remain low. This concept of a neutral level for short-term
real interest rates is referred to in the academic literature as r* and corresponds to the rate
consistent with a level of aggregate demand equal to and growing in pace with aggregate
supply at an unchanged rate of inflation. Longer-run secular trends in r* largely, or even
entirely, reflect fundamental "real" factors that are outside the control of a central bank.
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Policymakers and academics alike, including myself, have spent considerable time
exploring the reasons for and ramifications of the decline in r* across countries.3 For
example, many have pointed to slowing population growth and a moderation in the pace
of technological change as consistent with a lower level of r*.4 Changes in risk tolerance
and regulations have led to an increase in savings and in the demand for safe assets,
pushing down yields on sovereign bonds.5 Importantly, economic theory suggests and
empirical research confirms that there is a significant common global component
embedded in individual country r*s (figure 3, "Estimates of r*").6 This common factor
driving individual country r*s not only reflects the influence of common global shocks
affecting all economies in a similar way (for example, a slowdown in global productivity
and the demographics associated with aging), but also results from international capital
flows that respond to and, over time, tend to narrow divergences in rates of return offered
across different countries. Other things being equal, a decline in the common factor
driving individual country r*s that is evident in the data would be expected to produce a
comparable common decline in global bond yields.
In addition to the decline in r* around the world, lower long-term bond yields also
reflect the influence of the initial downshift and ultimate anchoring of inflation
expectations in many countries after the mid-1990s. Unlike the decline in r*, which
3
See, for instance, Fischer (2016a, 2016b, 2017) and Clarida (2019).
4
Most papers-such as Carvalho, Ferrero, and Nechio (2016); Gagnon, Johannsen, and Lopez-Salido
(2016); and Eggertsson, Mehrotra, and Robbins (2017)-estimate that demographics can explain between 1
and 2 percentage points of the decline in r*.
5
See Williams (2016, 2017); Caballero, Farhi, and Gourinchas (2017); Glick (2019); Chen, Karabarbounis,
and Neiman (2017); and Dao and Maggi (2018) for a discussion of the potential drivers for the increase in
the supply of savings and increased demand for safe assets. Other factors cited for lower real rates include
low productivity growth (Rachel and Summers, 2019) and secular stagnation due to insufficient aggregate
demand (Summers, 2015).
6
See Holston, Laubach, and Williams (2017); Clarida (2019); and Jorda and others (2019).
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primarily reflects fundamental "real" factors that are outside the control of a central bank,
the decline and ultimate anchoring of inflation and inflation expectations in both major
and many emerging economies were the direct consequence of the widespread adoption
and commitment to transparent, flexible inflation-targeting monetary policy strategies.
For example, in the United States, after the collapse of Bretton Woods, inflation spiraled
upward, hitting double-digit rates in the 1970s and early 1980s. But by the mid-1980s,
the back of inflation had been broken (thank you, Paul Volcker), and total personal
consumption expenditure (PCE) inflation averaged less than 4 percent from 1985 to
1990. Following the 1990-91 recession, inflation fell further, and, by the mid-1990s, the
conditions for price stability in the United States had been achieved (thank you, Alan
Greenspan). From the mid-1990s until the Great Recession, U.S. PCE inflation averaged
about 2 percent. And, of course, this step-down in inflation has been global, with the
other major advanced economies experiencing a similar shift down (table 1, "Average
Inflation Rates"). Many major emerging market economies as well have seen a
remarkable and very welcome decline in average inflation rates as a result of adopting
and delivering on credible inflation-targeting polices. To the extent that the step-down in
inflation is expected to persist, which appears to be the case, long-term yields have
reflected this decline one-for-one.
However, not only has the average level of inflation fallen, but inflation has also
become more stable. After considerable volatility in the 1970s and 1980s, over the past
few decades, inflation-especially core inflation, which excludes volatile food and
energy prices-has, with rare exceptions, moved only within a relatively narrow range in
many countries despite significant swings in the prices of oil and other commodities,
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recessions, the Global Financial Crisis, and unprecedented monetary policy actions.
Reflecting this, inflation volatility, as measured by the standard deviation in quarterly
inflation rates, has declined. (See table 2, "Standard Deviation of Annualized Quarterly
Headline Inflation Rates.")
What has been behind this global decline in inflation volatility? I would argue, as
have many others, that monetary policy played a key role in reducing not only the
average rate of inflation, but also the volatility of inflation.7 Inflation-targeting monetary
policy can plausibly influence the variance of inflation through several channels. For
example, in a textbook DSGE (dynamic stochastic general equilibrium) model (Clarida,
Galí, and Gertler (CGG), 1999) featuring a central bank that implements policy via a
Taylor-type rule, the equilibrium variance of inflation will be lower the more
aggressively the central bank leans against exogenous shocks that push inflation away
from target. So even if the variance of inflation shocks is constant, the variance of
inflation itself will be an endogenous function of monetary policy. Another related
channel through which monetary policy can influence the variance of inflation is by
changing the equilibrium persistence of inflation deviations from target. In the textbook
CGG model (1999), augmented with a hybrid Phillips curve that features an inertial
backward-looking component, the equilibrium persistence of inflation is an endogenous
function of the monetary policy rule such that the more aggressively the central bank
leans against exogenous shocks that push inflation away from target, the less persistent
are inflation deviations from target in equilibrium. In the simple case in which
equilibrium inflation is a first-order autoregressive process (as it is in the CGG (1999)
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model under optimal policy), the equilibrium unconditional variance of inflation is
monotonic in inflation persistence for any given constant variance of inflation shocks. Of
course, non-monetary factors may also have contributed to a lower variance of inflation.
For example, the variance of underlying exogenous shocks to aggregate supply and
demand may have fortuitously and coincidentally fallen in tandem with the adoption of
inflation targeting in many countries.
I will now turn to a third factor behind the decline in global bond yields, the
decline in term premiums that is estimated to have occurred in many countries over the
past 20 years. Most studies find that term premiums have fallen substantially in major
economies over the past 20 years, and that in the United States term premiums may have
been negative for some time. Decomposing the factors that drive equilibrium term
premiums is an active area of academic research, and I will not attempt to summarize or
synthesize this vast literature.8 But I would like to emphasize what seems to me to be
three contributors to the decline in the term premium in the United States and perhaps in
other countries as well.9
First, the decline in inflation volatility has almost certainly been important in
driving the term premium on nominal bonds lower. The real ex-post payoff from holding
a nominal bond to maturity is directly exposed to price-level risk, and thus, all else being
equal, a decline in inflation volatility makes the real purchasing power of the bond's
payoff less risky. Through this channel, the decline in inflation volatility should be
reflected in a smaller inflation risk premium in nominal bond yields, which is exactly
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what is estimated in the Kim, Walsh, and Wei (2019) yield curve model (figure 4, "Term
Premium Decomposition"). Indeed, this yield curve model attributes around 100 basis
points of the decline in the U.S. 10-year nominal term premium since the early 1990s to a
decline in the inflation risk premium.
A second likely contributor to the decline in the U.S. term premium over the past
decade is the Federal Reserve's substantial purchases of long-duration Treasury securities
and mortgage-backed securities in three large-scale asset purchase (LSAP) programs and
one maturity extension program between late 2008 and late 2014. These purchases,
which were concentrated at the longer end of the U.S. yield curve, took duration out of
the market and thus lowered the equilibrium yield required by investors to hold the
reduced supply of long-duration assets instead of holding and rolling over short-maturity
Treasury bills. Estimates of the cumulative effect of these purchases on the U.S. term
premium span a wide range, with some estimates above 100 basis points.10 Moreover,
the global market for sovereign bonds and currency-hedged duration is tightly integrated,
and it seems likely that asset purchase programs in other major economies, such as Japan,
the euro area, and the United Kingdom, have contributed as well to reducing the term
premium in Treasury securities (and, of course, LSAP programs in the United States
likely contributed to lower term premiums abroad).
A third contributor to a lower U.S. term premium is much less widely appreciated
than lower inflation volatility and LSAPs. This reflects the value that bonds have
provided over the past 20 years as a hedge against equity risk. As documented by
Campbell, Sunderam, and Viceira (CSV) (2017) and Campbell, Pflueger, and Viceira
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(CPV) (forthcoming), the empirical correlation between U.S. bond and stock returns
changed sign in the late 1990s from positive to negative (figure 5, "Bond-Stock
Covariance in the United States"). In the 1970s and 1980s, the sign of the correlation
was positive, which implies that bond and stock returns tended to rise and fall together.
In this period, bonds provided a diversification benefit when added to an equity portfolio
(the bond return beta to stocks averaged 0.2) but not a hedge against equity risk. Since
the late 1990s, the empirical correlation between bond and stock returns has typically
been negative (the bond return beta to stocks has averaged negative 0.2). This means that
since the late 1990s, bond returns tend to be high and positive when stock returns are low
and negative so that nominal bonds have been a valuable outright hedge against equity
risk. As such, we would expect the equilibrium yield on bonds to be lower than
otherwise, as investors should bid up their price to reflect their value as a hedge against
equity risk (relative to their value when the bond beta to stocks was positive). According
to CSV, the hedging value of nominal bonds with a negative beta to stocks could
substantially lower the equilibrium term premium on bonds. Quoting from their paper
(page 265),
"Thus from peak to trough, the realized beta of Treasury bonds has
declined by about 0.6 and has changed sign. According to the CAPM
[capital asset pricing model], this would imply that term premia on 10-
year zero-coupon Treasuries should have declined by 60 percent of the
equity premium."11
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As a concrete example, consider the (ex-post) hedging value of bonds for equity risk in
the Global Financial Crisis. In 2008, the total return on the S&P 500 index was around
minus 37 percent, while the total return of the on-the-run 30-year Treasury bond was
about 38 percent!
There is likely no single explanation for the change in sign of the correlation
between equilibrium bond and stock returns in the United States and in other major
countries (figure 6, "Bond-Stock Covariances in Advanced Economies").12 One recent
paper that does rigorously model the changing value of bonds for hedging equity risk is
by CPV. This paper develops and estimates a habit persistence consumption asset pricing
model in which the sign of the equilibrium covariance between equity and bond returns
depends on the reduced-form correlation between inflation and the output gap, the
correlation between the federal funds rate and the output gap, as well as the equilibrium
persistence of inflation. CPV document in U.S. data, for a sample spanning 1979:Q3 to
2011:Q4, that (1) the correlation between inflation and the output gap changed sign from
negative to positive; that (2) the correlation between the federal funds rate and the output
gap changed sign, also from negative to positive; and that (3) the evidence of the sign
change becomes statistically significant beginning in the late 1990s. CPV also document
that the transitory component of inflation becomes much less persistent after the
estimated break in their sample.
The CPV paper is agnostic as to why the reduced-form correlation between
inflation and the output gap and that between the federal funds rate and the output gap
both change sign in their sample, but the authors do demonstrate that in their asset pricing
model, these reduced-form sign changes are sufficient to generate the sign change in the
correlation between equity and bond returns that we observe in the data.
I, myself, believe that the change in the U.S. monetary policy regime that began in
1979 under Paul Volcker and that was extended by Alan Greenspan in the 1990s very
likely contributed to the change in the sign of the correlation between inflation and the
output gap as well as the change in sign of the correlation between the federal funds rate
and the output gap that we observe in the data (Clarida, Galí, and Gertler, 2000). These
are the sorts of patterns that a simple model of optimal monetary policy would produce
when starting from an initial condition in which inflation is well above the (implicit)
target, as was the case in 1979. High initial inflation triggers a policy response for the
central bank to push up the real policy rate well above inflation in order to push output
below potential, which, via the Phillips curve, will, over time, lower inflation toward the
target. If this policy succeeds ex post, inflation expectations become anchored at the new
lower level of inflation, and policy can, then, respond to demand shocks by adjusting real
rates pro-cyclically, the opposite of what is required when initial inflation is too high and
inflation expectations are not anchored.13 Inflation will also be pro-cyclical with well-
anchored inflation expectations if demand shocks dominate and inflation expectations
remain anchored.
Implications for Monetary Policy: The Federal Reserve's Framework Review
By lowering expected inflation, by anchoring expected inflation at a low level, by
contributing to a reduction in the volatility of inflation-and thus a reduction in the
inflation risk premium-and by contributing to creating a hedging value of long-duration
sovereign bonds, inflation-targeting monetary policy has lowered equilibrium bond yields
relative to equilibrium short rates substantially compared with the experience of the
1970s and early 1980s. But, as I noted earlier, during the past decade equilibrium short
rates have themselves also fallen substantially. These two phenomena, taken together,
have resulted in sovereign bond yields that are substantially lower than the pre-crisis
experience and thus substantially closer to the effective lower bound for the policy rate
than they were before the crisis. But what does this mean for monetary policy? At its
most basic level, the answer to this question could depend on how far the nominal policy
rate is from the effective lower bound (ELB) and the extent to which the term premium
on long-duration bonds can become even more negative than it is at present (at least in
the United States).14 While I do not have a precise answer to this question, I will confess
that I think it highly unlikely in the next downturn, whenever it is, that 10-year U.S.
Treasury yields will fall by the roughly 390 basis points that we observed between June
2007 and July 2016 (the bottom in Treasury yields in this cycle) or even decline by the
roughly 360 basis points that we observed between January 2000 and June 2003.
The reality of low neutral rates and equilibrium bond yields has motivated us at
the Federal Reserve to take a hard look this year at our monetary policy strategy, tools,
and communication practices. While we believe our existing framework, in place since
2012, has served us well, we believe now is a good time to step back and assess whether,
and in what possible ways, we can refine our strategy, tools, and communication
practices to achieve and maintain our goals as consistently and robustly as possible in the
world we live in today.15 As I have noted before, the review of our current framework is
wide ranging, and we are not prejudging where it will take us, but events of the past
decade highlight three broad questions that we will seek to answer with our review.
The first question is, "Can the Federal Reserve best meet its statutory objectives
with its existing monetary policy strategy, or should it consider strategies that aim to
reverse past misses of the inflation objective?" Central banks are generally believed to
have effective tools for preventing persistent inflation overshoots. But persistent inflation
shortfalls, such as those associated with the ELB, carry the risk that longer-term inflation
expectations become anchored below the stated inflation goal.16 At our September
Federal Open Market Committee (FOMC) meeting, we discussed options for mitigating
ELB risks, including "makeup" strategies in which policymakers would promise to make
up for past inflation shortfalls with a sustained accommodative stance of policy intended
to generate higher future inflation.17 Such strategies provide accommodation at the ELB
by keeping the policy rate low for an extended period. Makeup strategies may also help
anchor inflation expectations more firmly at 2 percent than would a policy strategy that
does not compensate for past inflation misses. But the benefits of makeup strategies
depend importantly on the private sector's understanding of them as well as the belief
that future policymakers will follow through on promises to keep policy accommodative.
An advantage of our current framework over makeup approaches is that it has provided
the Committee with the flexibility to assess a broad range of factors and information in
choosing its policy actions, and these actions can vary depending on economic
circumstances in order to best achieve our dual-mandate goals.
We are also considering whether our existing monetary policy tools are adequate
to achieve and maintain maximum employment and price stability, or whether our toolkit
should be expanded and, if so, how. Because the U.S. economy required additional
support after the ELB was reached in 2008, the FOMC deployed two additional tools
beyond changes to the target for the federal funds rate: balance sheet policies and
forward guidance about the likely path of the federal funds rate.18 The review is
examining the efficacy of these existing tools, as well as additional tools for easing policy
when the ELB is binding, in light of the more recent experiences of other economies.
Finally, we are focusing on how the FOMC can improve the communication of its
policy framework and actions. Our communication practices have evolved considerably
since 1994, when the Federal Reserve released the first statement after an FOMC
meeting.19 As part of the review, we are assessing the Committee's current and past
communications and additional forms of communication that could be helpful.
18
As an illustration of the shortfall in policy support created by a binding ELB during the Global Financial
Crisis, the simple policy rules considered in a January 2017 speech by then-Chair Janet Yellen prescribed
setting the federal funds rate between negative 1-1/2 and negative 9 percent; see Yellen (2017). In addition
to using these two additional monetary policy tools, the Federal Reserve implemented a number of other
measures to stabilize the financial system, increase household and business confidence, and more generally
support the economic recovery. These supplementary measures included the setting up of several credit
facilities and the introduction of stress tests for systemically important financial institutions.
19
Over the past decade or so, the FOMC has enhanced its communication both to promote public
understanding of its policy goals, strategy, and actions and to foster democratic accountability. These
enhancements include the Statement on Longer-Run Goals and Monetary Policy Strategy; post-meeting
press conferences; various statements about the principles and strategy guiding the Committee's
normalization of monetary policy; and quarterly summaries of individual FOMC participants' economic
projections, assessments about the appropriate path of the federal funds rate, and judgments of the
uncertainty and balance of risks around their projections. Starting in 1979, the Federal Reserve published a
summary of individual economic projections from various Board members, FOMC members, or FOMC
participants in the semiannual Monetary Policy Report. With the introduction of the Summary of
Economic Projections (SEP) in 2007, the FOMC increased the frequency of the releases of policymaker
In terms of process, we have heard from a broad range of interested individuals
and groups in 14 Fed Listens events this year. At our July 2019 FOMC meeting, the
Committee began to assess what we have learned from these events and to receive
briefings from System staff on topics relevant to the review.20 But we still have much to
discuss at upcoming meetings. We will share our findings with the public when we have
completed our review, likely during the first half of 2020.
Concluding Remarks
The economy is constantly evolving, bringing with it new opportunities and
challenges. One of these challenges is how best to conduct monetary policy in the new
world of low equilibrium interest rates. It makes sense for us to remain open minded as
we assess current practices and consider ideas that could potentially enhance our ability
to deliver on the goals the Congress has assigned us. For this reason, my colleagues and I
do not want to preempt or to predict our ultimate findings. What I can say is that any
refinements or more material changes to our framework that we might make will be
aimed solely at enhancing our ability to achieve and sustain our dual-mandate objectives
in the world we live in today.
Stepping back, earlier today, speakers at this conference discussed the challenges
of making monetary policy in an uncertain and risky environment. In my remarks, I have
laid out an important example of the interaction of the macroeconomy, monetary policy,
and the market response to risk. The papers you are about to discuss throughout the next
two days present cutting-edge research on the effect and measurement of risk and
uncertainty and volatility, with a special focus on monetary policy and market behavior.
As someone on the front lines, I look forward to learning from your insights and
encourage your rich discussion over the next few days and your continued work on how
to make my job easier! Thank you, and good luck!
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