Ben S Bernanke: What policymakers can learn from asset prices
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, before The Investment Analysts Society of Chicago, Chicago, 15 April 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
Central bankers naturally pay close attention to interest rates and asset prices, in large part because
these variables are the principal conduits through which monetary policy affects real activity and
inflation. But policymakers watch financial markets carefully for another reason, which is that asset
prices and yields are potentially valuable sources of timely information about economic and financial
conditions. Because the future returns on most financial assets depend sensitively on economic
conditions, asset prices - if determined in sufficiently liquid markets - should embody a great deal of
investors' collective information and beliefs about the future course of the economy.
I thought you might find it interesting to hear a bit about how the staff of the Federal Reserve uses
financial-market information to try to improve forecasts and help guide policy decisions. As you will
see, asset prices provide information, particularly about market expectations, that is difficult to obtain
elsewhere. However, a recurring theme of my remarks will be that extracting accurate information from
asset prices and yields is more difficult and requires greater sophistication than is commonly
supposed. Ongoing research in financial economics thus has great potential to provide practical
assistance to monetary policy makers.
As usual, the views I will express today are not necessarily those of my colleagues in the Federal
Reserve System.1
Market expectations of inflation: the information in inflation-indexed securities
I will begin by discussing what financial markets can tell us about inflation expectations. The inflation
expectations of financial-market participants are of particular interest to central bankers, for several
reasons. First, as price stability is a key objective of monetary policy, the Federal Reserve puts
substantial resources into forecasting inflation. To the extent that financial markets serve to aggregate
private-sector information about the likely future course of inflation, data on asset prices and yields
might be used to validate and perhaps improve the Fed's forecasts. Second, inflation expectations are
of interest to policymakers independent of inflation itself. A considerable literature suggests that
successful monetary policies should stabilize, or "anchor," inflation expectations so as to prevent them
from becoming a source of instability in their own right (Goodfriend, 1993; Evans and Honkapohja,
2003). Finally, knowledge of the expectations of inflation in financial markets permits the calculation of
real interest rates, which are important indicators of both the condition of the economy and the stance
of monetary policy.
Although clues about inflation expectations abound in financial markets, inflation-indexed securities
would appear to be the most direct source of information about inflation expectations and real interest
rates.2 Government securities whose realized yields depend on inflation, known on the Street as
"linkers," have become increasingly common in industrial countries, Japan being the latest nation to
introduce an inflation-indexed government bond. The U.S. Treasury began issuing TIIS (for Treasury
inflation-indexed securities), more popularly known as TIPS (for Treasury inflation-protected
securities), in January 1997. TIPS promise a yield-to-maturity that is guaranteed in real terms. To
provide the promised real yield, TIPS coupon and principal payments are escalated based on
increases in the consumer price index from the time at which the security was issued.
The difference between the real yield guaranteed by an inflation-linked security and the nominal yield
provided by a conventional security of the same maturity is known as the breakeven inflation rate or,
alternatively, as inflation compensation. The top panel of Figure 1 shows the yield on nominal ten-year
Treasury bonds (top line) and the real yield on ten-year TIPS since 1999 (bottom line). The vertical
distance between the two lines is known as breakeven inflation at the ten-year horizon. The bottom
panel uses overlapping issues of nominal securities and TIPS to disaggregate breakeven inflation into
the rate that applies to bonds maturing five years from now and the implied forward breakeven rate
from five to ten years out. The breakeven rate of inflation is often treated as a direct reading of
investors' expectations of inflation. Under this interpretation, the lower line in the bottom panel of
Figure 1 is an estimate of market inflation expectations over the next five years, and the upper line
represents five-year forward expectations of inflation, that is, today's expectation of what average
inflation will be between 2009 and 2014.
Unfortunately, as a measure of market participants' expected inflation, breakeven inflation has a
number of problems (Sack, 2000; Shen and Corning, 2001). First, and probably the most important,
breakeven inflation includes a return to investors for bearing inflation risk, implying that the breakeven
rate likely overstates the market's expected rate of inflation. Estimates of the inflation risk premium for
bonds maturing during the next five to ten years are surprisingly large, generally in a range between
35 and 100 basis points, depending on the time period studied (Ang and Bekaert, 2003; Goto and
Torous, 2003; Buraschi and Jiltsov, 2004). If the inflation risk premium averages 50 basis points, for
example, then breakeven inflation will overstate the market's true expectation of inflation by half a
percentage point, a substantial amount. A further complication is that inflation risk premiums are not
constant but instead appear to vary over time as economic circumstances change.
Second, although the issuance of inflation-protected securities has risen significantly, the outstanding
quantities of these securities remain much smaller than those of conventional Treasury securities.
Moreover, TIPS are attractive to buy-and-hold investors, in contrast to nominal Treasury securities,
which are extensively used for trading and hedging (Sack and Elsasser, 2004). For both reasons, the
market for TIPS remains significantly less liquid than those for most Treasury securities. All else equal,
the likely presence of a liquidity premium in the TIPS return tends to make breakeven inflation an
underestimate of expected inflation, thus offsetting to some degree the effect of the inflation risk
premium.3 Like inflation risk premiums, liquidity premiums on TIPS appear to vary over time, further
complicating the interpretation of breakeven inflation.
A third issue is that the real values of the coupon payments on an indexed security are fixed by
construction, while the real coupons of a nominal bond usually decline over its life. Hence, an indexed
security typically has a longer duration with respect to real interest rate changes than does the nominal
security, a difference that affects the relative riskiness of real and nominal securities.4 More generally,
because TIPS returns are imperfectly correlated with the yields on both nominal Treasuries and
stocks, some investors demand TIPS for general diversification purposes - a demand that appears to
have increased significantly as investors have become more familiar with this new type of asset. As
the supply of TIPS has been fairly limited, the rise in demand by institutional investors and others may
push down the equilibrium real return on TIPS and thus raise measures of breakeven inflation.5
A separate issue that bears on the relevance of breakeven inflation for policymaking is that TIPS
returns depend on the overall consumer price index (CPI), whereas for many purposes policymakers
are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food
and energy prices. In fact, TIPS returns appear sensitive to fluctuations in oil prices.
3
As a partial fix of this problem, the breakeven inflation rates shown in Figure 1 are calculated by comparing the yields of
TIPS and so-called off-the-run securities. Within a given class of securities, say Treasury bonds with ten years until maturity,
off-the-run securities are securities other than those most recently issued. Because off-the-run securities are less liquid than
newly issued (on-the-run) securities, they provide a more appropriate benchmark against which to compare the yields of
relatively illiquid inflation-indexed bonds.
4
As Sack (2000) has pointed out, this difference in duration implies that the breakeven inflation rate may be sensitive to the
expected profile of future short real rates or be affected by differences in risk premiums arising from different exposure to
interest-rate risk. Sack addressed the issue of differing durations of nominal securities and TIPS by comparing yields on
TIPS to yields on artificial securities constructed to provide the same pattern of real payments as a TIPS security, thereby
eliminating the differences in duration noted in the text. He found, however, that the duration mismatch is less important
quantitatively than differences in liquidity between on-the-run nominal securities and TIPS.
5
A number of technical issues, such as the lags in the inflation adjustment procedure, affect the relationship of breakeven
inflation and expected inflation. One such potential complication arises if the tax rates applicable to the marginal TIPS
investor and to the marginal holder of nominal government securities are not the same, in which case the equilibrium
breakeven inflation level will be affected. Roll (2004) discusses the effects of taxation on the breakeven inflation rate.
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As you can see in Figure 1, breakeven inflation rates have proven surprisingly volatile over their short
history. For example, when nominal Treasury yields swung sharply during the spring and summer of
2003, ten-year breakeven inflation moved sharply as well, declining about 40 basis points as the bond
market rallied, then rising about 80 basis points when nominal yields came back up (top panel). This
effect was seen also in inflation compensation at the five-to-ten-year horizon (bottom panel), a rather
counterintuitive result.
What should we make of the volatility of breakeven inflation over recent years? One interpretation is
that inflation expectations are not as well anchored as policymakers would like (see Bernanke, 2004,
for additional evidence on this point). The fact that inflation compensation tends to react strongly both
to releases of macroeconomic data and to unexpected changes in monetary policy (Gurkaynak, Sack,
and Swanson, 2003) supports this interpretation.
Still, at this point I think we need to be cautious about drawing strong conclusions about the short-run
behavior of expected inflation from the data on breakeven inflation. The fact that the volatility of
breakeven inflation is so much greater than that of standard survey measures of inflation expectations
(such as those collected by the Federal Reserve Bank of Philadelphia for professional forecasters or
by the University of Michigan for consumers) should give us pause. The responsiveness of breakeven
inflation to what might be construed primarily as liquidity disturbances, such as the Russian debt crisis
and recent bouts of mortgage hedging activity that roiled Treasury markets, suggests that variable
liquidity premiums, together with varying inflation risk premiums, contaminate breakeven inflation as a
measure of expected inflation.6
I have emphasized some reasons to be cautious in interpreting breakeven inflation as expected
inflation. Nevertheless, I expect that the usefulness of inflation-indexed securities as a tool for
measuring expected inflation will increase over time. The liquidity of TIPS should continue to improve
as the share of government debt issued in inflation-linked form continues to rise, particularly if the
Treasury decides to expand the range of maturities of indexed bonds that it offers. Moreover, as I will
discuss briefly later in the talk, our ability to model risk and liquidity premiums is improving, which will
help us control for an important source of volatility in breakeven inflation. Finally, the universe of
inflation-linked financial assets seems to be increasing, which will allow for fruitful comparisons and
cross-checking. For example, futures on the CPI were recently introduced on the Chicago Mercantile
Exchange. Although these contracts are not yet widely traded, they may at some point provide useful
measures of breakeven inflation out to the maturity of the shortest-term TIPS, thereby filling in an
important portion of the term structure of breakeven inflation.
Interest rates and spreads as leading indicators
An alternative approach to extracting information from financial markets is to examine a range of asset
prices and yields to determine whether they are useful as leading indicators of economic
developments. Financial prices meet several key criteria for being useful leading indicators. As I
already noted, asset prices and yields are inherently forward looking and thus may contain information
about future economic conditions not evident in other series. Moreover, asset prices, unlike many data
series, are available on a timely and continuous basis and are not revised. At least since the 1930s,
when Wesley Mitchell and Arthur Burns (1938) published their pioneering work, economists have
noted the usefulness of asset prices in forecasting economic activity - though perhaps we should keep
in mind Paul Samuelson's wry observation that "the stock market has predicted nine of the last five
recessions."
Although many financial quantities have been used in forecasting (an index of stock prices is included
in the official index of leading indicators), interest rates on various financial instruments have perhaps
been most often cited for their value as leading indicators.7 For example, in a 1992 paper, Alan Blinder
and I found evidence that the federal funds rate, the short-term interest rate used by the Federal
Reserve as its policy instrument, has significant predictive power for a variety of measures of
economic activity.
Various yield spreads have also been found to be informative about the future course of the economy.
In 1989, James Stock and Mark Watson proposed a new index of leading indicators based on seven
variables with exceptionally good forecasting track records up to that date. Among these variables
were the spread between the ten-year and one-year Treasury yields (the term spread), the yield
differential between commercial paper and Treasury bills (the public-private spread), the change in the
ten-year Treasury yields, and the nominal exchange rate.8 Thus, Stock and Watson found that two of
the best seven macroeconomic forecasting variables were interest rate spreads, and four of the best
seven forecasters were financial in nature.
Of these variables, the term spread (also known as the slope of the yield curve) had been recognized
for some time as a useful indicator of cyclical conditions. Figure 2 shows the historical behavior of the
term spread (top panel, here measured as the ten-year rate less the three-month rate), as well as that
of the federal funds rate and the spread between commercial paper and three-month T-bill yields for
comparison. The shaded areas indicate periods of recession as designated by the National Bureau of
Economic Research. It is interesting that the slope of the Treasury yield curve has turned negative (top
panel), at least briefly, at between two and six quarters before every U.S. recession since 1964 (Ang,
Piazzesi, and Wei, 2003). It has given only one false signal, in 1966, when an economic slowdown
- but not an official recession - followed the inversion of the yield curve. The slope of the yield curve is
potentially informative for several reasons. To some extent, it captures the stance of monetary policy.
For example, when the yield curve is sharply upward sloping, as is the case today, one can usually
conclude that monetary policy is in an expansionary mode (because the short-term policy rate lies
below the average of expected future short-term rates). Either an expected pickup in economic growth
or higher expected future inflation would also tend to raise long-term rates relative to short rates,
steepening the yield curve. Evidence for the predictive power of the slope of the yield curve has been
found for other industrialized countries as well as for the United States.9
Although the evident information content of the term spread and other yields and spreads is intriguing,
these variables - like breakeven inflation - hardly provide a foolproof forecasting tool. For example, the
Stock-Watson indicator and other indicators based on interest rates and spreads signaled the 1990-91
recession very weakly and rather late. The yield curve was inverted from June 2000 through March
2001, which presaged the 2001 recession, but other financial indicators (such as the public-private
spread) missed the downturn entirely (Stock and Watson, 2003a), as you can see in Figure 2. More
generally, Stock and Watson (2003b) have recently documented that simple forecasting relationships
are typically quite unstable, presumably because both the nation's economic structure, the conduct of
policy, and the mix of shocks that buffet the economy change over time.
Although the use of financial data as leading indicators is not without risks, I suspect that economists
will continue to try to find better ways to extract the information in these data. I see two general
approaches as being especially promising. First, forecasting relationships that simultaneously use
information from a large number of data series may be more robust than prediction equations based
on only a few variables (Stock and Watson, 2003b). One effective way to summarize the information in
large data sets is through the estimation of statistical models that extract the common information
conveyed by many variables.10 Currently, the U.S. Treasury uses a model of this type in preparing its
forecasts of gross domestic product (GDP), and the Chicago Fed's national activity index, which draws
on earlier work by Stock and Watson, is also based on these methods. The Board staff is currently
investigating the potential of this approach for forecasting the economy.
The other promising approach is to combine financial and macroeconomic information in a more
structured way. For example, Ang, Piazzesi, and Wei (2003) have used modern financial theory to
construct a model of the Treasury yield curve that closely links the behavior of real GDP and a few key
interest rates. In particular, their framework incorporates the possibility of two-way causality, allowing
for both interest-rate effects on the economy and the impact of economic developments on interest
rates. These authors show that combining financial and macroeconomic elements in a single model
permits better forecasts of both GDP and of interest rates than can be achieved through less formal
methods.11 Other work, for example by Ang and Bekaert (2003), shows how modeling the links
between interest rates and the economy may help us obtain more efficient forecasts of inflation. These
methods are also being studied at the Federal Reserve Board.
One important advantage of this theory-based modeling approach is that it permits the estimation of
risk premiums. For example, presumably the predictive power of the term spread would be enhanced
if we could separate changes in the spread resulting from changes in rate expectations from those
arising from changes in risk premiums. Similarly, better estimates of inflation risk premiums would
prove useful for adjusting breakeven inflation rates from TIPS to get more reliable measures of
expected inflation.
Market expectations of monetary policy
What do markets expect about the future course of monetary policy? The question is important to
policymakers, not because we are concerned necessarily that we should meet the market's
expectations - such a strategy quickly degenerates into a hall of mirrors - but as a check on the
efficacy of our communication. If the policy expectations of the market differ significantly from the
policy expectations of central bankers, then the two leading possibilities are, first, that the policy
committee has not accurately communicated its outlook and objectives or, second, that the market
hears the policy committee's message but is skeptical of it.
A number of financial instruments provide readings on the market's policy expectations. Two of the
most useful are federal funds futures contracts and eurodollar futures contracts. These contracts are
traded in highly liquid markets.12 Moreover, by their nature they are closely tied to expectations of
monetary policy changes, as both reflect rates paid in the interbank market, the market that is targeted
by the Federal Reserve's open-market operations.13
Implied forward values of short-term interest rates at various horizons can be extracted from federal
funds and eurodollar futures contract prices in a straightforward way. Figure 3 provides an illustration.
The lower, dashed line shows the path of the expected federal funds rate through 2008 as implied by
federal funds and eurodollar futures at the close of the market on April 1, 2004, with an adjustment for
the average level of term premiums. The upper, solid line shows the path of expected funds rates as of
the market close on the next day, April 2. As you probably know, the payroll employment numbers
announced on April 2 significantly exceeded market expectations. Figure 3 shows that the payroll data
seems to have caused the market to price in an expectation of a higher federal funds rate target over
the entire policy horizon. Of course, that change in policy expectations is consistent with the significant
rise in Treasury yields that occurred after the employment report.
Observing market expectations of policy provides useful feedback to the policymakers. Yet again,
however, caution is needed in interpreting these data. As with inflation-indexed securities, forward
interest rates implied by futures contracts do not necessarily correspond to market expectations of the
short-term rate, because of the presence of premiums for interest-rate risk.14 Indeed, research
suggests that risk premiums in federal funds and eurodollar futures contracts are not trivial and may
vary over time. For example, a study by Piazzesi and Swanson (2004) has found that risk premiums
on federal funds futures are both strongly countercyclical and predictable at longer horizons. The
implication is that, although futures prices provide good estimates of market expectations of policy at
short horizons of six months or so, at longer horizons they can be misleading. In particular, Piazzesi
and Swanson (2004) find that if analysts ignore risk premiums in federal funds and eurodollar futures,
they will estimate longer-horizon policy expectations that "lag behind" actual market expectations,
remaining too high when the Fed is easing and too low when the Fed is tightening.15 Fortunately, this
research also shows how to correct the futures data to account for the time variation in risk premiums.
Once again, we see that some subtlety is required to extract the information available in asset prices.
A great advantage of market-based measures of policy expectations, relative to periodic surveys that
ask market participants about their expectations, is that market measures are available essentially
continuously.16 These measures thus lend themselves to "event studies" of two types, both of which
are employed at the Board of Governors. The first type analyzes how various events, such as Federal
Reserve statements; the release of minutes, testimony, or speeches by members of the Federal Open
Market Committee (FOMC); and macroeconomic news affect market expectations of monetary policy.
One simply compares the implied policy expectations before and after the event being studied. We
have already considered an example, the effects of the most recent payroll report, in Figure 3.
Analyses of this type provide insights for policymakers into the question of what economic factors the
"market," viewed collectively, is focusing on at a given time.
The second type of event study uses market-based measures of policy expectations to analyze the
effects of policy changes on the economy. In particular, when the FOMC chooses to set the target for
the federal funds rate at a value different from that expected by the market, asset prices tend to react
strongly. For example, in a recent paper, Kenneth Kuttner and I (2004) studied the effects on stock
prices of unanticipated changes in monetary policy, as measured by settings of the federal funds rate
target that differ from those implied by federal funds futures market. We found that a surprise increase
of 25 basis points in the funds rate target typically results in a decline in broad equity indexes of about
1 percent, whereas a change in the funds rate that is expected by the market has essentially no effect
on stock prices.17 Our work is just one example of a number of event-study analyses that may well
shed light on the effects of monetary policy and the channels of monetary policy transmission.
Policymakers are concerned not only about market expectations of output, inflation, interest rates, and
other key variables, but also about the extent of market uncertainty about those and other variables.
Financial data provide insight about market uncertainty that is obtainable nowhere else. For example,
the Board's staff regularly analyzes the prices of options on eurodollar futures to estimate the degree
of uncertainty that market participants have about monetary policy at different horizons. Indeed, by
examining options with different strike prices, and under some reasonable additional assumptions, one
can produce a full probability distribution of market expectations for the level of the federal funds rate
at various dates in the future. Likewise, analysis of various types of options can generate distributions
of expectations for economic and financial variables ranging from oil prices to the exchange value of
the dollar to future stock prices.18
Conclusion
Financial markets aggregate enormous amounts of information and thus provide a rich hunting ground
for central bankers trying to learn about the economy. Today I have tried to provide a small taste of the
many types of financial data that are analyzed by the staff at the Federal Reserve as well as to give
you some sense of the techniques that they bring to bear. A message that I also hope to leave with
you is that some of the potentially most valuable information in financial markets often requires
considerable theoretical and empirical sophistication to extract. For this reason, and as I mentioned at
the beginning, financial research of the type being conducted at the Board, in academia, and in the
investment community will prove invaluable to the Federal Reserve in our efforts to support a stronger
and more stable economy.
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