Jean-Claude Trichet: Risk and the macro-economy
Keynote address by Mr Jean-Claude Trichet, President of the European Central Bank, at the
conference "The ECB and its Watchers X", Frankfurt am Main, 5 September 2008.
* * *
Ladies and gentlemen,
After an extended period of ample financial market liquidity and exceptionally low rewards for
risk, the loss in the value of important classes of real assets has imparted a sharp
deterioration in investor appetite. Rises in commodity prices, by eroding consumers'
purchasing power and real income prospects, have reinforced households' risk aversion.
A long phase of heightened risk tolerance in our economies has come to an end. To the
extent that the more recent turns in the markets correct past excesses, this is a welcome - if
painful - process that we had anticipated and asked market participants to prepare for in
past interventions.
At the same time, the decline in the compensation for risk that the recent turmoil has partly
reversed is not a recent development. It started a quarter of a century ago, in tandem with -
and probably reflecting - what seems to have been a persistent decline in macroeconomic
uncertainty. So, to the extent that this moderation in macroeconomic fluctuations - in
aggregate risk - would be confirmed as a permanent acquisition of modern economies, there
is some reason to believe that the trend to lower risk valuations - beyond the needed
corrections of the more recent excesses - could in the end reassert itself.
In this talk I will reflect upon some evidence that lies at the heart of the mechanisms through
which risk valuation makes contact with real economic decisions. The ultimate aim of my
reflections is to find hints about the fundamental value of risk.
Theories, for which I have some sympathy, have it that there is a historical break in risk
valuation in the markets, and the realisation of that break largely mirrors structural
developments in the balance between savings and investment on a global scale. China's
phenomenal growth in domestic manufacturing capacity and income production was not
matched by an equi-proportional growth in domestic spending capacity - so Chinese savings
grew ahead of even the dramatic pace at which domestic investment has expanded. At the
same time, the aftermaths of the East Asian crisis brought about an "investment strike" in
many economies bordering on the Asian Pacific, and taught authorities in those countries
that bigger liquidity buffers - denominated in safe Western currencies - were needed to
defend themselves against the volatile behaviour of foreign private investors. Finally,
international financial markets were called upon - once again - to recycle the massive
hardcurrency balances that were being accumulated by commodity exporting countries. All this
has made saving - and wealth - abundant ex ante relative to investment and income. And
has led to a downside adjustment in the rewards that investors can claim to receive in
compensation for their finance.
These developments at time have dominated the financial landscape. But the breaks in the
evolution of the market rewards for risk on which I will focus date long before the rise of the
Asian economies and the increase in commodity prices. So, I will search for a fundamental
connection between financial risk and macroeconomic performance in the developed
countries, which will be the focus of my remarks. What is the direction of this link? Does the
Great Moderation determine the quantum of risk traded in the markets? Or does the price of
risk determined in the financial markets contribute and partly determine those fluctuations?
And what is structural in this link - and thus likely to persist beyond short-term volatilities -
and what is transient?
A complete understanding of these relations would bring invaluable insights for policy
considerations. For one thing, the centrepiece of dynamic macroeconomics is the equation of
savings to investment. Asset prices - and the risk remuneration that they embody - are the
mechanisms that do all this equating. Therefore, sustained movements in risk premia of the
size that we have seen in the past quarter of a century are bound to have important
implications for the allocation of consumption and investment across times and states of
nature, and for the determination of aggregate demand at any point in time and in any
economic state. I will also mention new - to some extent unknown - forms of interactions
between financial markets and the real economy.
One possibility that many observers have contemplated is that the prices determined in the
market for key factors of production - such as energy or other commodities - might be
increasingly influenced by forces and trading strategies that are motivated by the financial
drive toward portfolio diversification, beside the desire to secure access to a physical
delivery. Again, the way these markets might be pricing financial risk might make the
interpretation of those prices more difficult.
Unfortunately, my conclusion is that the state of our knowledge is not advanced enough to
draw definitive conclusions about the nature and the directions of influences between risk
pricing and the macro-economy. I will nevertheless submit my conjectures and lay out some
basic behavioural principles that could help policymakers minimise major losses amid the
uncertainty surrounding the current economic juncture.
I also appeal to the many distinguished scholars that sit in front of me today to concentrate
their minds to elucidate these relations.
1. Risk premia and macroeconomic conditions
There is no univocal way to assess whether asset values are high or low relative to economic
norms. Popular commentary often focuses on price indices and how they deviate from
longterm averages. But, of course, index levels can vary because of general price inflation, or
growth in the real economy, or changes in the size of publicly traded assets relative to the
economy. So, it is customary for analysts to scale asset prices in various ways.
A summary statistic of valuations that abstracts from scaling problems is the "asset risk
premium", or the rate of excess return investors expect to earn over the long run from their
investment at current prices.1 If the asset generates uncertain payoffs, investors ask to be
compensated for this risk, which they would not bear if they chose to hold a competiting
security with comparatively more predictable returns. The risk premium represents this
reward. For a given stream of expected cash flows, a higher risk premium today signals a
diminished willingness to hold the risky asset or, equivalently, a higher required return for
doing so. Higher returns can be generated only by future price appreciation from a lower
current price. So, an increase in the premium today is associated with a capital loss in the
form of a drop in the current price of the asset. Conversely, a low premium signals a high
current price relative to the expected income stream discounted at the risk-free rate.
The risk premium measures the attractiveness of a risky investment relative to risk-free
alternatives. Indirectly, it is a measure of the market's appetite for investment risk.
These figures [Figures 1a, 2a and 3] document the basic facts that constitute the subject of
my considerations on the risk and the macro-economy. I focus here on estimates of the risk
premia paid on four important asset classes: equity, houses, government bonds and
corporate credit securities. They span the four markets for external finance that are most
critical to the functioning of modern economies: the market for capital, installed in businesses
and in residential establishments, and the market for credit, to government and corporate
borrowers. I use US and euro area observations, whenever these are available, but
international evidence broadly confirms this picture. And I concentrate on the last quarter of a
century when the movements which I shall reflect upon are most evident.
What do we see in these pictures? Two things: First, if I emphasise trends rather than waves,
I see that risk premia on a representative spectrum of assets have declined more or less
consistently since the middle of the 1980s. This is another way to say that the market price of
those assets has tended to appreciate relative to the stream of their expected payoffs,
discounted at the risk-free rate. Second, looking at higher-frequency movements around
trends, I notice a turnaround in some financial series toward the end of the period. In
particular, equity and credit financing has become more costly for firms to obtain, as the risk
premia required for holding stocks and credit securities have recently bounced back from the
lows achieved earlier. The upswing in the equity risk premium came first. The violent reversal
in the credit risk premia is even more recent history.
Understanding these trends and co-movements is an important pre-condition for any
inference we need to draw on the more recent turnarounds. So, I shall concentrate on
lowfrequency movements first, and come back to my interpretation of the turnarounds and the
future at the end of my talk.
Why have required excess returns - risk premia - on, say, stocks trended down? Many
explanations specific to the market for business capital are conceivable. One is that
expectations of future cash-flows in the form of dividend payments might have consistently
lagged behind ex post realisations, which in the end drive stock prices.2 For example, the
potential for sustained economic growth in excess of historical precedents, the availability of
ex ante
profitable investment projects beyond the frontier that was considered attainable
might explain a fraction of the decline in required stock returns over a certain phase.
Why have term premia on bonds trended down? Again, specific factors affecting the market
for safe financial investments have been cited. I have mentioned already that the rapid
expansion of incomes in countries with high propensities to save meant that a large share of
their increased demand for assets was directed to the risk-free financial liabilities of primary
sovereign issuers, most prominently the US Treasury.
Similarly, trends in the market for homes and for private credit can be given explanations
rooted in housing preferences and the evolution of default rates through time.
2
Referring to the formula in the previous footnote, and interpreting {dt}t=0...∞ as the actual (ex post) stream of
dividend payments, systematic underprediction of the dividend stream looking forward from any given vantage
point t can result in an underestimation of the return that can be expected, at t, from holding the stock at the
current price pt because the market price grows at the growth rate of the actual dividend payments.
BIS Review 105/2008
But there is one question which remains, beyond all these explanations.3 They all are too
specific to one market. As we see, declines in returns have been generalised. Estimated
premia in the stock market in 2008 lie one third and two thirds below their values at the
beginning of the 1980s, in the euro area and the US respectively. In the meantime, term
premia on the bond market have lost three fourth of their estimated value at the middle of the
1990s in a seemingly relentless fall spanning the entire period for which we could compute
them. The premium for investments in houses has followed a similar trend, despite a sharp
reversion, in particular in the US in the most recent period. Finally, the cost of corporate
borrowing in excess of a riskless rate [Figure 3], which remunerates credit risk, has also
decreased significantly in both economies, although its trend is punctuated by significant
oscillations in the opposite direction. Obviously we observe the same movements across the
board.
Facts common to multiple markets suggest the existence of a common factor, something
truly related to the size of the required premium for holding all types of risky assets. If the
compensation for bearing risk is compressed in all markets, this must reflect that either the
quantity of macroeconomic risk has gone down, or the price at which investors trade that risk
has declined, or some combination of these two possibilities.
In these two further pictures the quantity of aggregate risk is proxied by
[Figures 1b and 2b],
the macroeconomic uncertainty introduced by the volatility of real per-capita consumption
growth [- as measured by rolling standard deviations of per-capita real consumption
growth -] and the level of inflation in the two economies.4 Unfortunately, the price that
markets attach to that quantity - agents' risk aversion - is not directly observable or easily
approximated by observable variables. I shall come back to this point later.
Why concentrate on consumption volatility as a proxy of real macroeconomic uncertainty?
Because this is the privileged statistic of macroeconomic conditions in consumption-based
asset pricing models, the standard tool of financial economics. In these models, it is the
marginal utility of consumption and its variance that should help price real payoffs in different
states of nature.5 Why focus on inflation as an indicator of nominal uncertainty? If the level of
inflation is correlated with its perceived variability, then the level of inflation should influence
people's views of the degree of uncertainty that surrounds their macroeconomic
environments. If the nominal scale of the economy is more firmly secured, financial markets
will likely reflect it in lower premia.
3
In fact there are more problems. First, explaining low equity risk premia with systematic under-prediction of
income streams has limited explanatory power. If anything, the scant evidence available on earnings
expectations point in the opposite direction. Sharpe (1999), for example, finds that in the period between 1994
and the end of the century forecasts of two-year nominal earnings growth were high and stable (between 10%
and 15%), even though realised two-year earnings growth were declining. It should also be noted that higher
growth in realised payoffs, per se, is not sufficient to account for price movements over the entire sample,
because dividend-to-price and earning-to-price ratios have themselves trended down. The secular fall in the
dividend-to-price and earnings-to-price ratios is actually the fact that needs to be explained in the first place.
See, among many others, Jagannathan, McGrattan and Scherbina (2000). Second, concerning low term
premia, foreign official purchases of US bonds - by the monetary authorities of countries which follow a stable
exchange rate policy vis-à-vis the US dollar - was found to have played little or no role as a factor contributing
to low long-term interest rates in a study of the interest rate conundrum. See Rudebusch, Swanson and Wu
(2006).
4
The level of inflation is found to be correlated with its variability, which in turn should influence people's
perceptions of the degree of uncertainty that surrounds their macroeconomic environments.
5
In many standard asset-pricing models with complete markets, the risk premium, or excess return, paid by an
asset with uncertain payoffs is proportional to the volatility of consumption, with a risk aversion parameter as
the constant of proportionality. In these models, aggregate consumption volatility stands for the quantity of
risk, while the parameter scaling agents' risk aversion stands for the price of risk. A crucial subsidiary
assumption behind this logic is that all wealth - including human capital - is tradable, so that the aggregate
return can be interpreted as the gross return to an asset that represents a claim to aggregate consumption.
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The drawn-out moderation in real macroeconomic volatilities - the Great Moderation - is a
well-known fact. It has been persistent, as the pictures indicate, and broad, spreading
beyond inflation and consumption to virtually all sectors and components of income, on a
global scale, as many studies have demonstrated.6 The tight correlation between the risk
premia priced in various markets and movements in macroeconomic risk is less known,
however. It is certainly of great interest to policymakers.7
It is a challenging piece of evidence for two reasons. Because causation can run both ways,
from macroeconomic volatility - the quantum of non-diversifiable risk - to risk compensation
in the financial markets, or from the market determination of the reward for risk - the market
price of risk - back to the macroeconomic equilibrium. And because both chains of causation
entail a blend of structural and contingent factors: factors that are likely to last and factors
that are transient and bound to be reversed.
Therefore, in September 2008 a scholar, a forecaster, a policymaker looking back to the
financial history of the last quarter of a century for clues about the proximate future
evolutions faces two questions. First, what determined the compression of risk in virtually all
markets: was it a reduction in aggregate risk, or was it a compression in the price for which
markets trade and distribute that risk? Second, whatever the cause, did the compression of
risk reflect permanent shifts in fundamental connections, or was it transient?
A lot - not least in terms of policy decisions - is conditional on a clear identification of these
links, of these directions and their nature.
1.1 The quantum of risk: what is structural and what is transient?
Staring at the statistical association between premia and macroeconomic volatilities it would
be tempting to draw a line of causation running from declining macroeconomic risk to falling
premia. The decrease in macroeconomic uncertainty associated with the fall in the volatilities
of consumption and inflation can arguably be expected to have resulted in a corresponding
reduction in the uncertainty on future asset returns, thus leading to lower risk premia across
the board. In the case of government bonds, for example, a decrease in macroeconomic
volatility reduces the risk of unexpected future changes in interest rates - perhaps
policyinduced - and removes one primary source of return uncertainty that investors in bonds have
to hedge against in less tranquil times.8 For corporate bonds and commercial paper, a
decrease in the amplitude of business-cycle fluctuations should bring about, ceteris paribus,
a lower probability of default, which, once again, can translate into lower credit risk premia.
Analogous reasoning holds for stock and housing markets, with the fall in macroeconomic
volatility translating into a decrease in the uncertainty about expected future returns, and
therefore leading to lower risk premia.
However, even if one is prepared to entertain the possibility that the line of causation runs
predominantly from macroeconomic conditions - fundamental macroeconomic stability - to
asset price determination, the prospects for the evolution of market prices in the near future
are vastly conditional on the nature of the macroeconomic moderation.
If one believes that the main reason for the observed decline in macroeconomic volatilities -
and, indirectly, for low risk compensations and high prices in asset markets - is that policy
regimes have become more stable, more predictable and confidence-inspiring, then
prospects for market participants and policymakers alike will be brighter. We all know that the
institutional roots of the Great Moderation are significant, as studies done at the ECB and
elsewhere have shown.9 We know that policy statutes - disciplining monetary policy and the
fiscal authority - have been carefully crafted in many countries to make sure that stable
policy conditions are put in place and are there to last. So, if all this is true, one could
perhaps confidently extrapolate the moderate macroeconomic volatilities of the past into the
future. And, in so doing, one would equally be reassured that the down-trends in risk
compensation that we have observed for so long - beyond short-run ups and downs - would
not be reversed in a sustained manner.
But the same line of causation could be less reassuring from another angle. The same
studies that have found an important role for policies in the Great Moderation of the last two
decades cannot certainly rule out that "good luck" might have exerted a reinforcing influence.
More moderate exogenous shocks might have contributed - more or less accidentally - to
smoothing economic fluctuations. In the terms of our picture, this would be equivalent to say
that the moderation in some non-policy factor driving activity might have been responsible for
the fall in inflation and consumption variability.
To the extent that this interpretation has some merit, a less fortunate string of shocks could
always bring more ample swings in economic conditions - looking forward - than we have
grown accustomed to from past experience. And this could entail repercussions for the
valuation of investment risk in various financial markets. In this case a return to historical
valuations for risk would imply large negative returns for a possibly extended period of time.
1.2 The price of risk: what is structural and what is transient?
It is important to understand that the close co-movements that appear when comparing
trends in premia with trends in macro-volatilities are not inconsistent with an alternative,
inverse pattern of causation: one predominantly running from financial market prices to the
macro-economy.
Exogenous changes in financial markets may have caused an original fall in risk premia.
Since asset prices provide signals for profitable investment opportunities, affect the wealth of
households, and influence the cost of capital to firms and households, a compression of risk
premia in the markets for capital and credit may have put the economy on a different
expansion path where incomes grow faster and are less uncertain.
But, again, independent changes in financial markets can be of a structural or more transient
nature.
I shall start with structural factors. A major source of structural evolution in financial markets
over the last twenty years, one that is difficult to overlook and that is likely to last, comes
under the encompassing label of increased financial market participation. Institutional
investors, such as pension and mutual funds, hedge funds, and more recently sovereign
wealth funds, have been playing an increasingly important role in many asset markets. The
informed, active trading of these investors has increased market liquidity and led to a
reduction in transactions costs. Deeper and less expensive markets have meant that the
typical investor - once holding a poorly diversified portfolio with skewed returns - is now
better diversified and thus more risk-tolerant. At the same time, the introduction of
nonredundant and previously non-existing assets and liabilities has provided a further
encouragement for investors and financial intermediaries to transform and transfer risk. The
enhanced availability of these new instruments has increased the accessibility and
availability of credit to the private sector. I will return to the toxic side of these developments
in a minute. Here, as in many studies, I note that an increase in participation has the
potential to decrease the required risk premium on a wide spectrum of assets, because it
spreads market risk over a broader population.10
For a given amount of macroeconomic risk - a given quantum of macro-volatility - increased
participation can cut the price of risk. And a lower price of risk that is due to a structural break
in market participation rates is more likely to persist.
But transient factors in financial markets might have been at work as well. For a given
quantum of macro-volatility and a given fundamental price of risk, markets can at times
under-appreciate the former and under-price the latter. Risk aversion can fluctuate around a
fundamental value which is determined by long-lasting evolutions in financial market
infrastructures and financial market participation. And these more contingent fluctuations in
risk aversion can be slow to re-absorb. Changes in risk aversion can at times look a lot like
"bubbles". But swings in risk aversion that will eventually revert back to some sort of
equilibrium are, in my view, the manifestation of a phenomenon - more general than
"bubbles" - which has been rationalised and modelled in various ways.11 The important point
is not so much to understand what causes such fluctuations in risk preferences - whether
explosive expectations12 or habit formation in consumption - but that they are ephemeral
and, once they take off, they tend to fall back to ground.
Occasional waves of higher risk tolerance in financial markets can expand the supply of
external finance for the productive sector and for government. And this can make previously
unprofitable investment programs look attractive, which can boost growth. But, unlike more
structural shifts in financial market infrastructures, occasional turns in risk tolerance are just
that: occasional.
Reversion to some sort of steady values for risk appetite can undo established market trends
and give rise to a prolonged period of strains in market valuations.
10
The emergence and growth of new financial intermediaries can have further and deeper causes. For example,
the more recent, accelerated integration of emerging markets into the global economy may have led to an
increase in global savings and, as a result, to a growing demand for financial services and new financial
operators. Also, the achievements of peak-savings years by the baby-boom generation might have expanded
the pool of resources that need to be intermediated by specialised pension funds. In fact, the abundance of
global savings - whether induced by the globalisation of economic processes or by the aging of a large share
of the world population - is indeed one of the explanations advanced for the exceptionally low bond yields
recently observed in the U.S. and, to a lesser extent, also in the Euro area.
11
For example, models in which investors' preferences display habit formation - the argument of utility is not the
absolute level of consumption but the level of consumption relative to some "normal" level - can generate
time-varying risk tolerance. Agents are more risk averse when current consumption is around the level that
they consider "normal" based on their past income/consumption history. In these circumstances - which
indeed should apply in normal times - only a small fraction of consumption is available as a surplus to
generate utility, and even small shocks to consumption can have a large effect on this surplus. Therefore,
investors are extremely risk averse. A positive shock to income can cause actual consumption to exceed its
perceived "normal" by a wide margin and for a prolonged period of time. This increases agents' risk appetite
because now the consumption surplus is larger. Campbell and Cochrane (1999) prove that the (equity) risk
premium can fluctuate due to this mechanism.
12
Within the cash-flow-discount model for asset pricing that is expounded in footnote 2, seemingly explosive
price dynamics can be generated by a sequence of negative innovations to the risk premium, πt.
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2. New channels of interaction
Varying risk premia blur the fundamental connection between asset prices and real economic
decisions. This has been studied extensively and the evidence that I have provided thus far
is, after all, but one variation on a traditional theme in financial economics: the risk premium
puzzle.
But today risk pricing and macroeconomic performance can make contact in ways that are
novel and still little known. Here I would like to draw your attention to the increased
participation of financial investors - especially hedge funds and institutional investors - in
commodity markets.13 This trend has accompanied the spectacular boom in commodity
prices over the last few years and has complicated the interpretation of the fundamental
drivers of prices in those markets in various phases.
We can take the oil futures markets as an example. Futures contracts are agreements to buy
or sell a specified quantity of a commodity at a future date, at a price agreed upon when
entering the contract, the futures price. However, in regulated exchanges [such as NYMEX
or ICE] these contracts are traded chiefly for hedging risk on price changes rather than for
arranging physical delivery of oil.14 Traditionally, these markets have been characterised,
more frequently than not, by a market constellation of prices known as "backwardation". This
indicates a situation in which futures prices are below the current spot price
[see Figure 4].15
To understand what this means, note that both producers and consumers of oil are normally
interested in hedging the risk of fluctuations in the future spot price of oil - which is unknown
today. But, since oil production and supply is concentrated among far fewer participants than
total consumption among consumers, suppliers are more likely to factor the risk of future
price fluctuations into their economic decisions to a larger extent than any single buyer. This
strengthens the incentive for suppliers to hedge against adverse fluctuations in spot prices.
Traditionally, the market for oil futures has been a "sellers' market." And sellers have been on
average happy to pay a premium to market traders willing to buy a futures contract and take
upon themselves the risk of future spot price declines. "Backwardation" means that buyers as
a whole normally agree to provide this insurance if they can expect to earn a positive
premium on top of the expected change in the future price of oil.16 Assuming that the best
predictor of the spot price in the future is the current spot price, the spread between the
current spot price and the futures price reflects the remuneration for the risk that buyers as a
whole accept to bear.17
Over the last two decades when backwardation has been the norm, the risk premium paid by
hedgers to financial investors has been relatively stable, moving predictably with the spot
13
See, for example, Domanski and Heath (2007).
14
Although physical delivery of oil may occur, this in reality occurs rather rarely. Contracts are instead liquidated
before expiration usually leading to exchange of cash among market participants. So, for example, while an
airline normally buys jet fuel through its usual physical supplier, it can purchase a futures contract to hedge
possible price increase over the subsequent months. If the price actually rises, the gain from liquidating the
futures contract towards expiration will offset the loss from the greater cost of fuel.
15
The opposite situation in which the term structure of futures prices is upward sloping is known in traders'
jargon as "contango", and has traditionally occurred less frequently than "backwardation".
16
Some financial participants may be enticed to buy or sell futures contracts by different views on the future oil
price than the market. But on average financial participants are net buyers and assuming that they are on
average no better than sellers in predicting the future spot price, they will need a discount over the price
expected at the expiration of the futures contract to be motivated to purchase it.
17
This risk premium is the mirror image of what sellers as a group are willing to give up for the benefits of
holding physical inventories of oil, which have the important role of ensuring the continuation of production and
sale in the face of potential disruption in the oil supply chain. In jargon inventories provide a "convenience
yield", which in the oil market can be quite sizeable. The convenience yield is normally inversely related to the
deviation of inventories from their desired size.
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price of oil [Figure 4].18 More recently, since 2005, this relationship between the risk
premium and the spot price of oil appears to have changed and risk premia paid by hedgers
have been shrinking to become even negative between early 2005 and 2007.19 This is clear
from the evolution over time of the futures price curve [for Brent oil price], on which the ECB
oil price projections are based. The curve clearly moved from a downward slope to an
upward tilt around the same time and maintained the increasing tilt at least until the middle of
2007 [Figure 5].
This atypical compression - and inversion - of the risk premia paid in the oil futures market
has gone hand in hand with an appreciable change in the structure of these markets, w