Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Should Monetary Policy Monitor Risk Premiums in Financial Markets?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Should Monetary Policy Monitor Risk Premiums in Financial Markets?

Article excerpt

The recent financial crisis has reignited interest in whether monetary policy should respond to financial stability concerns such as asset price bubbles. Before the crisis, many believed monetary policy should respond to these concerns only to the extent they significantly alter the future outlook for inflation or unemployment. Proponents of this view regarded promoting financial stability by raising the cost of borrowing more than the outlook for inflation or unemployment warranted as undesirable because it might conflict with macroeconomic stability. However, the severity of the 2007-08 financial crisis and subsequent slow recovery challenged this view.

Recently, some policymakers have argued that monetary policy can and should play a more active role in preventing financial instability. Adjusting interest rates in response to risk premiums in financial markets could be an effective way to mitigate financial instability and the resulting macroeconomic instability. For example, if investors are underpricing adverse future outcomes, central banks could raise interest rates to increase the cost of risk-taking. Despite the importance of this suggested policy change, thorough investigations of the idea remain scarce.

Monitoring risk premiums might provide additional information about future macroeconomic outcomes that conventional indicators related to output and inflation do not typically reveal. As risk-averse investors become more or less concerned about relatively unlikely but potentially disastrous macroeconomic outcomes, risk premiums might change to reflect their perceptions. For example, a sudden spike in credit risk premiums could indicate an impending severe recession not evident from past and present macroeconomic indicators. Policymakers could mitigate the risk of a recession by choosing a more accommodative policy stance in response. On the other hand, unusually low risk premiums could reflect excessive risk-taking and call for a tighter monetary policy stance.

To reduce the probability of an adverse macroeconomic outcome, policy responses to risk premiums must meet two key conditions. First, for policymakers to have a chance to prevent a bad outcome, risk premiums must be useful in predicting future changes in economic growth. Second, monetary policy must be able to change risk premiums. If sudden shifts in risk premiums are predictable and monetary policy can affect them, then a policy stance more reactive to risk premiums could reduce the probability of a sharp decline in future macroeconomic activity. This article investigates whether risk premiums help predict future economic growth and whether monetary policy can affect risk premiums.

To assess predictability, a statistical analysis estimates the predictable portion of various risk premiums and real gross domestic product growth. The analysis indicates a prolonged period of low risk premiums can increase the probability of a severely adverse macroeconomic outcome, although the overall impact on expected future GDP growth is generally small.

Monetary policy could offset the adverse future economic effect of low risk premiums. A statistical analysis shows that an unexpected tightening of monetary policy increases risk premiums in the future. However, such policy tightening is expected to reduce GDP growth by raising the cost of borrowing and reducing aggregate spending. Thus, while a policy response to risk premiums could prevent an expected decline in future economic activity, it would come at the cost of lower economic activity in the near term.

Overall, the analysis suggests that if policymakers are concerned about tail risks such as the probability of a severely adverse macroeconomic outcome, adjusting short-term interest rates in response to various estimated risk premiums could be appropriate, especially if the risk premiums are low for a sustained period. In contrast, if policymakers are predominantly concerned about the most likely macroeconomic outcome, monitoring estimated risk premiums and adjusting the monetary policy stance accordingly may be of little benefit. …

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