Presentation to a conference
celebrating Professor Rachel McCulloch:
Trade Still Optimal in the 21st Century?”
Panel discussion: The State of the Global Economy/Current
International Economic Policy
Brandeis University, Waltham, Massachusetts
By Janet L. Yellen, President and CEO,
Bank of San Francisco
For delivery June 15, 2007, 12:20 PM Eastern, 9:20 AM Pacific
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Good afternoon. I’m delighted to take part in today’s
program honoring my long-time friend, coauthor, and former
colleague, Rachel McCulloch. In my remarks today, I would
like to focus on some aspects of the global economy that
are salient to me from the standpoint of monetary policy.
On the one hand, there is much that is heartening. World
economic growth has been robust during the last few years
and, in 2006, according to the IMF’s summary measure,
performance was extraordinarily strong—the best in
both overall and per capita terms since the early 1970s.
China and India both grew at a blistering pace. But, importantly,
growth was widely spread around most regions of the globe.
At the same time, inflation was reasonably low among the
advanced economies, and in most emerging markets and developing
countries, it was quite moderate by historical standards.
Conditions in global financial markets have been supportive
of growth. Real interest
rates and risk spreads have remained relatively low despite monetary tightening
by major central banks. Equity markets in many countries have hit new highs,
and emerging markets have seen increasing private capital inflows.
These good outcomes across a broad range of countries might
suggest that the world economy is not a very risky place.
But monetary policymakers are paid to
worry—to see dark clouds, not just silver linings. One worry, now longstanding,
relates to the large imbalances in saving and investment flows among countries
that underlie the current pattern of global growth. Standard debt dynamics suggest
that the large and growing U.S. current account current imbalance is unsustainable.
But theory offers little guidance on exactly how or when it may unwind. My concern
here is that a sudden unwinding of these imbalances could be associated with
sharp movements in exchange rates and asset prices that could produce destabilizing
economic impacts around the globe. Given the enormous expertise of this audience
on this issue, I will focus instead on a distinct but related worry, which concerns
the possibility and potential consequences of an abrupt and disruptive shift
in general risk tolerance in international financial markets.
At present, there are numerous indications that risk premia
are notably low—in the U.S. and also globally. One indication
is the low level of long-term bond
rates compared with expected rates on short-term debt in the U.S. and other
advanced economies. Of course, long-term rates have risen
in recent weeks, but not by
nearly enough to resolve what former Fed Chairman Alan Greenspan coined, “the
bond rate conundrum.” Another indication can be found in the very low options-based
implied volatilities on most types of U.S. financial instruments, including equities,
debt instruments, and exchange rates. Further indications are the narrow risk
spreads on both foreign private and sovereign securities, which are near historic
The phenomenon of low spreads may well reflect an environment
wherein risk genuinely is reduced. The volatility of both
output and inflation has declined substantially
in most industrial countries since the mid 1980s, a phenomenon known as the “great
moderation.” Recessions have become less frequent and less severe in most
industrial countries, and inflation has been low worldwide. Arguably, macroeconomic
management has improved significantly. Moreover, structural changes may have
improved the capacity of economies to absorb shocks. Since lower macroeconomic
volatility reduces the degree of uncertainty facing households and firms, it
may explain the lower risk premia.
In addition, a number of long-term structural developments
associated with technological change and deregulation have
reduced transactions costs, diversified and expanded
the variety of credit providers, and fostered the creation of new instruments
for allocating and pricing risk. For example, the providers of credit go well
beyond insured depository institutions to include asset managers, private equity
investors, and hedge funds. Some of the new instruments include collateralized
debt obligations, which permit illiquid loan obligations to be securitized,
and credit default swaps, which investors use as insurance
against corporate default.
Thus, financial innovations and deepening credit markets may have contributed
to a wider dispersion and a more efficient allocation of risks in financial
system and thereby to lower risk premia.
Finally, there may also be cyclical reasons for the decline
in risk premia. Even as short-term nominal rates have risen
in the U.S. and elsewhere in recent years,
low-interest-rate funds have remained available from other economies, notably
Japan and Switzerland. In addition, corporate leverage has been low, and this
has dampened credit market volatility because debt service costs are low and
the threat of default has declined.
My concern, however, is that investors may be underestimating
the risks in both in domestic and foreign markets as indicated
by a number of investment strategies.
For example, here in the U.S., the rapid rise of lending at variable rates
in the subprime mortgage market may have reflected an unduly
benign view of the
underlying risks, and some lenders have paid a high price for this view. Inflows
into hedge funds have soared and private equity firms are borrowing at low
interest rates with favorable terms, resulting in a wave
of leveraged buyouts in both
the U.S. and abroad. Some observers question whether the supposedly sophisticated
investors in these funds fully understand the complexities of the investment
strategies pursued by fund managers and the risks to which they are exposed.
In foreign markets, investor demand for emerging market
assets has continued to expand, with inflows into dedicated
bond and equity funds in those countries,
including instruments denominated in local currencies, without much increase
in risk spreads. Low costs of borrowing have also attracted money into “carry
trades,” where investors borrow short-term at lower rates in one currency
and invest, unhedged, in riskier, higher-yielding bonds in another currency.
This strategy exposes investors to substantial exchange rate risk.
There is, of course, some research into why risk might
be underpriced, but so far, the answers remain tentative.
Some have pointed to the greater role of investment
managers in this more deregulated, competitive environment. These managers
may have incentives to herd with other investment managers
in order not to underperform
their peers, and they may also have incentives to take more “tail” risks,
in cases where compensation is weighted more towards achieving positive returns,
without sufficient regard for low probability negative returns. In addition,
the apparent confidence of investors that extreme events will not occur has
fostered increased demand for higher yield in riskier assets, resulting in
As we know from past experience, of course, the possibility
of a sudden reversal in risk perceptions cannot be ruled
out. Some recent reversals have had fairly
limited effects. For example, in May and June of 2006, rising interest rates
increased volatility in advanced economies, sparking a period of turbulence
in emerging markets. In late February of this year, there
were sharp movements in
global financial markets, sparked by a drop in China’s fledgling stock
market, as investors reacted to news about fundamentals in the U.S. and elsewhere,
but markets soon recovered.
But it does not take a very long memory to recall the serious
consequences of the Asian financial crisis of 1997-98 which
eventually escalated into one of
global proportions. In that instance, an abrupt increase in investor risk aversion
provoked sharp asset price declines and a frightening and sudden erosion of
market liquidity. Fortunately, in the years since that crisis,
the global financial
system has arguably become far stronger. Many countries have taken advantage
of the benign global environment and have reduced the ratio of public debt
to GDP, improved the currency and maturity composition of
debt, and increased international
reserve holdings. They have also undertaken measures to increase the resilience
of their financial markets, such as promoting the development of local currency
bond markets. Their banking systems, too, have been buttressed by stronger
supervision, thereby reducing the likelihood of devastating
banking failures. Furthermore,
the widespread adoption of more flexible exchange rate regimes creates greater
scope for monetary policy and hence the potential to contain the economic spillovers
of such turbulence.
From a policy perspective, a natural question is what,
if anything, central banks, including the Federal Reserve,
can and should do to address potential risks associated
with the possibility of excessive risk-taking in global financial markets.
To mitigate the risks of financial instability, I believe
that policymakers must
mainly rely on supervisory tools and prudential regulation to ensure that financial
institutions are properly capitalized and that they carefully and comprehensively
identify, assess and manage risks of all types—market, credit, and operational.
At the same time, the Federal Reserve is actively collaborating with other supervisors
in the United States and globally, and encouraging private sector initiatives
designed to strengthen the resilience of the financial sector and to improve
its ability to manage the stresses that might emerge in the event of an unanticipated
shift in risk preferences. A recent example involves credit default swaps. The
Federal Reserve Bank of New York has taken steps to promote private sector initiatives
to correct a serious problem of confirmation backlogs in these contracts and
to clarify the exposure of counterparties to them. In addition to mitigating
potential risks, central banks must be prepared to respond to events that may
have systemic effects. This requires understanding the nature of financial arrangements
and their implications for risk. To this end, the Fed supports research on financial
markets, communicates with institutions well beyond those we directly supervise,
and cooperates with financial supervisors around the world.
Some have espoused the view that central banks should go
further—tightening monetary policy to dampen overly euphoric
asset markets—to prick asset
price bubbles before they burst. I do not espouse that view because it is exceptionally
difficult to distinguish “bubbles” from fundamental-based booms and
monetary actions impose certain short-run costs for very uncertain future gains.
I therefore believe that central banks should stand ready to act to cushion the
economy in response to shocks when and if they occur.
1 R. Rajan, “Has Financial Development Made the World
Riskier?” The Greenspan Era: Lessons for the
Future, A Symposium sponsored by the Federal Reserve Bank
City. Federal Reserve Bank of Kansas City (2005), pp. 313-369.
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