Donald L Kohn: Monetary policy perspectives on risk premiums in financial
markets
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, at the Financial Market Risk Premiums Conference, Federal Reserve Board, Washington DC,
21 July 2005.
* * *
I am pleased to have an opportunity to participate in this conference on the time variation and
macroeconomic links of financial market risk premiums. Steven Sharpe, Paul Harrison, and Hao Zhou
are to be congratulated for putting together an interesting program that should advance our
understanding of this important topic. Although your papers concentrate on the equity premium, I
would like to take a few minutes today to broaden the discussion to encompass risk premiums in other
markets and to highlight the connections between risk premiums and monetary policy. My goal is not
to draw conclusions on recent movements in risk premiums but rather to give you a sense of how
estimates of risk premiums may influence our policy decisionmaking, to note some of the difficulties
that we face in interpreting their movements, and, I hope, to stimulate further research in this already
fertile field.1
At the Federal Reserve, we pay a lot of attention to financial market prices in the formulation of
monetary policy. Financial markets are the channel through which our policy affects the economy, and
asset prices contain valuable information about investors' expectations for the course of policy,
economic activity, and inflation, as well as about the risks around those expectations.
An important element in interpreting financial market prices is the identification of the risk premiums
they contain. To be clear, when I say "risk premium" I mean the additional compensation required by
investors for holding a risky security--that is, one with uncertain returns--above the compensation that
would be demanded by risk-neutral investors who care only about expected returns. For example,
while a risk-neutral investor would demand a certain spread on a junk bond over a risk-free rate of the
same maturity as compensation for expected losses, a risk-averse investor likely requires an even
wider spread depending on the covariance characteristics of the bond's total return. In the Treasury
market, risk--or term--premiums are generally evident as maturities extend and reflect mostly the
interaction of risk aversion and uncertainty about the future path of interest rates. When applied to
credit markets, the term "risk premium" is sometimes used in a broader sense to include expected
losses, but I am thinking of risk premiums as the extra compensation for the uncertainty around
anticipated economic and financial outcomes. This compensation is determined by both perception of
risks and investor preferences, or risk aversion.
Among the risk premiums that we monitor regularly at the Federal Reserve are those on equity
returns, equity volatility, corporate bonds, and Treasury securities. Each contains information about a
different risk around a different expected outcome. Clearly, the separation of market prices into distinct
pieces reflecting expected values and risk is a difficult task that relies heavily on modeling
assumptions about underlying processes and investor behavior. Indeed, think of all the constituents of,
say, a long-term corporate bond yield. Such a yield encompasses compensation for expected real
rates, for expected inflation, for expected default, and for the expected liquidity in the instrument, and it
contains conceptually separate risk premiums for uncertainty about each of these underlying factors.
In principle, an ideal model would account for each of those components separately. In practice,
however, we have yet to achieve such a fine breakdown, and the estimate of any one or group of
those components is likely to be highly dependent on the estimates of the others. Although some
promising research on modeling these components--jointly or individually--is under way, we need to be
especially aware of our theoretical and empirical limitations when interpreting market price
movements. But these qualifications do not diminish the point that risk premiums are certainly relevant
for monetary policy deliberations, and we do pay attention to our best estimates of them.
We, as policymakers, form our own independent view of the expected path of a number of
macroeconomic and financial variables, but we are also obviously interested in gauging investors'
expectations about the future paths of those same variables. Investor expectations shape the market
reaction to new economic data and to our policy actions, and when those expectations differ from our
own, they could embed information that we might wish to factor into our own analysis. Investors'
expectations are reflected in asset prices, but so are risk premiums, and inferences about future
economic conditions obtained from market prices are conditional on estimates of those premiums.
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. Nothing better illustrates the need to
properly account for risk premiums than the current interest rate environment: To what extent are
longterm interest rates low because investors expect short-term rates to be low in the future due to some
underlying softness in aggregate demand, and to what extent do low long rates reflect narrow term
premiums, perhaps induced by well-anchored inflation expectations or low macroeconomic volatility?
Clearly, the policy implications of these two alternative explanations are very different.
While judging investors' expectations is important when setting monetary policy, so is understanding
investors' sense of the distribution of possible outcomes around those expectations. Market risk
premiums may well be an input into our own perceptions of the range of possible economic outcomes,
and our policy actions can be influenced by those perceptions. For example, our reaction to a scenario
in which inflation is low and is expected to vary within a narrow band would presumably be different
than our reaction to an alternative scenario in which inflation uncertainty was high and there was a
significant chance of entering a deflationary environment. Thus, we are also interested in risk
premiums as indicators of uncertainty and not solely as inputs into accurate readings of investors'
mean economic outlook.
So far I have largely considered risk premiums as indicators of economic conditions, but they can also
directly affect real economic activity. For example, the decline in term premiums in the Treasury
market of late may have contributed to keeping long-term interest rates relatively low and,
consequently, may have supported the housing sector and consumer spending more generally. Also,
risk premiums may be, in part, a manifestation of investor sentiment, which in turn may be correlated
with consumer and business sentiment. Accordingly, it is possible that risk premiums may reflect
broader "animal spirits" in a Keynesian sense, and thus they could be a marker for shifts in underlying
business and consumer spending trends. Consider the dramatic example of the turnaround in equity
markets from 2000 to 2003: The pullback of both real and financial risk-taking that accompanied it
surely was a significant drag on the economy. Risk premiums may even have a role in credit cycles:
Some research here at the Board has shown that corporate bonds issued when risk premiums are low
default at a higher rate than bonds issued when risk premiums are high, even when conditioning on
their observable risk.2 Other research has drawn similar underperformance conclusions about stock
returns following initial public offerings.3
Finally, risk premiums are also important tools for monitoring financial stability. A strong, stable
financial system is of vital importance both for a robust economy and as a support for an effective
monetary policy. Information that bears on investors' attitudes toward risk and on the functioning of
financial markets and financial institutions is thus undoubtedly valuable. It certainly was, for example,
in the fall of 1998, when virtually every risk premium measure that we monitor appeared to indicate a
sharp withdrawal from risk-taking on the part of investors. That withdrawal threatened financial stability
and, as a consequence, real activity; the Federal Open Market Committee's (FOMC) risk-management
approach to policy dictated that the target rate be eased enough to substantially reduce the odds on a
very adverse outcome.
As you can see, we read risk premiums in a variety of ways and for a variety of purposes. Because we
conduct policy in real time, our attention is often drawn to movements in risk premiums as they occur,
especially if they appear to deviate from long-established patterns. Thus, we try first of all to develop a
good understanding of the historical behavior of risk premiums. The top panel of the exhibit that I have
passed around shows crude estimates, put together by the Board's staff, of the risk premium on both
equities and corporate bonds going back to 1920. The equity risk premium is constructed by
subtracting the real Aaa corporate yield from the ratio of trend earnings to prices as a measure of
expected equity returns. The corporate bond risk premium is constructed as the expected excess rate
of return of Baa over Aaa corporate bonds using expected default rates from a simple regression
model. The configuration of risk premiums in the 1950s presents both similarities and contrasts to the
behavior of risk premiums in current times. That earlier decade, like the present, was a time of low
interest rates and low inflation, and the corporate bond risk premium was low, just as it is today. But
our estimates suggest that the equity premium for that period was substantially higher than it appears
to be today. To an extent, that may have been a manifestation of a lingering reluctance to hold equity
for a generation that had been chastened by the Great Depression; asset preferences apparently were
skewed in ways that could not be readily attributed to objective differences in the risks of holding credit
and equity claims on businesses.
The other aspect of the chart that stands out is the apparent decline in risk measures since the late
1970s and early 1980s. The moderation in real output volatility, along with the decline in inflation and
its stabilization around low levels, probably reduced perceptions of how much economic and financial
variables would possibly deviate from expectations and may thus account for part of the explanation
for the decline in risk premiums. I know part of this has already been discussed this morning, and will,
no doubt, also be featured during the remainder of the conference, given its fundamental nature and
potential to explain declines in risk premiums across markets. But 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?
However, even if we think we understand the trends, the challenges become more pressing when we
look at movements in, and relationships among, risk premiums as they happen. Our first challenge is
to determine when a movement is not just noise that will quickly reverse, but rather a signal of
something important that we need to understand as we formulate policy. For example, does the
backup in the equity risk premium over the past year arise from some deep-seated and long-lasting
macroeconomic cause that we need to consider for our policy decisions, or is it a mere blip? To
separate signal from noise, we try to look not only at the persistence of movements but also at their
correlation across markets. Is there a widespread increase or decrease in risk aversion or in perceived
risk that suggests a shift in underlying attitudes and expectations? If there is, the monetary authority
may well need to adjust the stance of policy as the FOMC did in the fall of 1998.
Disparate movements in risk premiums, such as those we witnessed in equity and fixed income
markets recently and that are highlighted in the bottom panel of the exhibit, are not unusual and can
occur for a number of reasons. For one, we are measuring premiums in various markets that have
different risk exposures. Securities with different pay-off structures naturally may react differently to a
given shock. For example, a relatively modest downward revision to expected spending may raise
more questions about returns on equity than on corporate debt. Alternatively, markets may be reacting
to different shocks, or to changes to the capital structure of firms; over the last few years, lengthening
debt maturities and increases in liquid asset holdings may have supported debt holders at the
expense of equity holders. Or, as in the 1950s, perceptions may shift as a consequence of recent
events. From time to time, risk premiums also may be affected by changes in demand and supply
driven by legal or regulatory requirements, by exogenous changes in issuance patterns, or by shifting
asset preferences for reasons unrelated to changing expectations or attitudes toward risk.
To repeat, divergences in risk premiums are not necessarily unusual if looked at from a historical
perspective. And surely different co-movements can reflect different risks--or risk shifts--and different
preferences--or preference shifts--which can change the equilibrium relation across markets. But an
understanding of what caused the divergent movements could be important for policymakers. For
example, changes in perceived risk in some specific markets might point to certain economic
weaknesses that policy may need to address. On the other hand, a shift in asset preferences that
raised premiums in some markets but lowered them in others could potentially leave overall financial
conditions, and their implications for spending, not much changed. Thus, it is important for
policymakers to look at risk premiums in their entirety, rather than in isolation, before reaching policy
conclusions.
Today I have mostly characterized policymakers as avid readers of risk perceptions across markets,
but our actions could affect risk premiums as well. For instance, 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. We have emphasized the
conditional nature of our discussions of future policy to help market participants calibrate their
assessments and price risk. To the extent that the decline in risk premiums induced by clearer policy
communication has accurately reflected the decrease in uncertainty, assets will be better priced.
Finally, 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.
My purpose today has not been to interpret or forecast risk premiums or the specific way in which they
will affect the future path of monetary policy. Rather, I have taken advantage of a captive audience of
researchers on this topic to try to impress on you the importance to the central bank of research along
these lines. By outlining how we use estimates of risk premiums and the complications we have
encountered, I hope I have given you a sense that we are a ready market for work that improves our
understanding of the topic. Any such improvement will help us interpret financial developments as we
conduct monetary policy in pursuit of our goals of economic growth and price stability.