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

##s 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'roberto perli and paul harrison, of the board's staff, made important contributions to this talk. 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