Richard H. Clarida, Vice Chairman, Board of Governors of the Federal Reserve System, 12.11.2019

well Thomas thank you for that that

introduction and it's a delight to be

back in Zurich one of my favorite cities

and and have a chance to interact with

Thomas and colleagues at the SMB really

one of the pillars of the global central

banking community so it's a real honor

and in particular I'm delighted to

participate in the second annual

conference on risk uncertainty and

volatility that's sponsored by the

Federal Reserve Board the BIS in the

Swiss National Bank and I'd especially

like to thank the Swiss National Bank

for hosting this event at an incredible

incredible facility in an incredible

spot this conference is part of

continuing work across all of our

institutions and the academic community

to better quantify and assess the

implications of risk and uncertainty I

am pleased that this year the focus of

the conference is on two of my

long-standing professional interest

financial interests markets and monetary

policy and a moment remarks today I will

not stray far from those interests I've

titled my talk monetary policy price

stability and equilibrium bond yields

success and consequences and in this

paper I will address an issue that has

been much in focus the second that our

decline in global bond yields

highlighting the role of monetary policy

in contributing to this decline and the

implications of this decline for the

conduct of monetary policy one of the

most remarkable and fundamental changes

in the global financial landscape has

been the steady and significant decline

in global sovereign bond yields from the

late 1980s when 10-year Treasury yields

in the US and sovereign rates and many

other countries were at or above ten

percent global bond yields in the

advanced economies have trended lower

two levels below two percent today we

all know this but it is dramatic to see

to see the chart when many of us do

our careers to understand and interpret

this decline it is useful to think of

the yield on a nominal ten-year bond as

the sum of two components investors

expectation over the next ten years of

the average level of short-term interest

rates plus a term premium the term

premium is the additional compensation

that bondholders require for assuming

the risk of holding a long duration

asset with greater exposure to interest

rate and inflation volatility

importantly according to economic theory

the equilibrium term premium can be

negative in this case which is relevant

today in the US and perhaps some other

countries the exposure to interest rate

and inflation volatility embedded in a

long maturity bond is more than offset

by the potential value of that bond in

hedging other risks for example equity

risk the expectation of the average

level of future short-term interest

rates can in turn be decomposed in the

average of future real interest rates

and expectations of future inflation

rates performing the standard

decomposition reveals that the decline

in long-term rates reflects decline in

all three of these components expected

real rates expected inflation and the

term premium I will now discuss each of

these components in turn with respect to

expected real short rates one reason

investors expect lower future interest

rates is that neutral interest rates

appear to have declined worldwide and

are expected to remain low the concept

of a neutral level for the short term

real rate is referred to in the academic

literature as our star and it

corresponds to the rate consistent with

a level of aggregate demand equal to and

growing in pace with arrogant supply and

an unchanged rate of inflation longer

run secular trends in our star largely

or even entirely reflect fundamental

real factors

that are outside the control of the

central bank policymakers and academics

alike have spent a lot of time exploring

the reasons for and ramifications of the

decline in our star across countries for

example many have pointed to slowing

population growth and a moderation in

the pace of technological change as

consistent with a lower level of our

star changes in risk tolerance and

regulation have led to an increase in

saving and the demand for safe assets

which are also pushing down yields on

sovereign bonds importantly economic

theory suggests an empirical research

confirms that there is a significant

common global component embedded in

individual country our stars this common

factor driving individual country are

stars not only reflects the influence of

common global shocks affecting all

economies in a similar way but also

results from international capital flows

that respond to and over time tend to

narrow divergences in rates of return

offered across different countries other

things being equal a decline in the

common factor driving individual country

are stars would be expected to produce a

comparable common decline in global bond

yields in addition to the decline in our

star around the world lower long-term

bond yields of course also reflect the

influence of the initial downshift and

ultimate anchoring of inflation

expectations in many countries after the


now of course unlike the decline in our

star which reflects fundamental real

factors that are outside the control of

the central bank the decline and

ultimate anchoring of inflation and

inflation expectations in both major and

emerging economies were the direct

consequence of the widespread adoption

and commitment to transparent flexible

inflation targeting monetary policy

strategies for example in the United

States after the collapse of Bretton

Woods inflation spiraled upward hitting

double-digit rates in the ninth

in 70s and early 1980s but might but by

the mid-1980s the back of inflation had

been broken thank you paul volcker

wherever you are and total inflation

averaged less than 4% from 85 to 1990

following the 1991 recession inflation

fell further and by the mid-1990s the

condition for price stability in the US

had been achieved and thank you to alan

greenspan wherever you are from the mid

1990s until the Great Recession US

inflation averaged about two percent and

of course this step down in inflation

has been global with other major

advanced economies and many emerging

economies experiencing a similar

downshift and just to document those

declines we have this table here now to

the extent that this step down in

inflation is expected to persist long

term yields have reflected this decline

one-for-one however not only has the

average level of inflation fallen but

inflation has also become more stable

after considerable volatility in the

1970s and 80s over the past few decades

inflation has moved only within

relatively narrow range in many

countries despite significant swings in

commodity prices recessions and

unprecedented monetary policy actions in

the great global financial crisis

document here just the decline in in

volatility of inflation that we've also

seen in the data what has been behind

this global decline in inflation

volatility I would argue as have many

others that monetary policy played a key

role in reducing not only the average

rate of inflation but also the

volatility of inflation inflation

targeting monetary policy complies ibly

influenced the various of inflation

through several channels for example in

a textbook DSGE model featuring a

central bank that implements policy vela

via a tailored type rule the equilibrium

variance of inflation will be lower the

more aggressively the central bank leans


ninis shocks that might push inflation

away from target so even if the variance

of the underlying shocks is constant the

variance of realized inflation will be

an endogenous function of monetary

policy another related channel through

which monetary policy can influence the

variance of inflation is by changing the

equilibrium persistence of inflation

deviations from target if you will the

half-life of those deviations again in a

textbook model augmented with a hybrid

Phillips curve that features some

inertial backward-looking component the

equilibrium persistence of inflation

dynamics will be an endogenous function

of monetary policy such that the more

aggressively the central bank leans

against inflation shocks the less

persistent will be inflation deviations

and the lower will be the endogenous

volatility of inflation now of course

non-monetary factors may also have

contributed to the lower variance of

inflation for example the variance of

underlying exogenous shocks to aggregate

supply and demand may have fortuitously

and coincidentally fallen in tandem with

the adoption of inflation targeting in

many countries I will now turn to a

third factor behind the decline in

global bond yields the decline in the

term premium that is estimated to have

occurred in many countries over the past

20 years most studies find that term

premiums have fallen substantially in

major economies over the past 20 years

and that in the u.s. term premiums may

have been negative for some time

decomposing the factors that drive term

premiums is an active area of academic

research and I will not attempt to

summarize or synthesize this vast

literature but I would like to emphasize

what seems to me to be three

contributors to the decline in the term

premium in the US and perhaps in some

other countries as well first the

decline in inflation volatility has

almost certainly been an important

driving factor making the term premium

lower on nominal bond yields the real

ex-post payoff from holding a nominal

bond of maturity is due

directly exposed to price level risk and

thus a decline in inflation volatility

makes the real purchasing power of the

bond less risky through this channel the

decline inflation volatility should be

reflected in smaller inflation and risk

premiums in nominal bond yields which is

exactly what we estimate in the term

premium model that we've developed and

that we use at the Fed indeed in the

feds yield curve model the model

attributes about a hundred basis points

of the decline in the u.s. term premium

to a decline in the inflation risk

premium a second likely contributor to

the decline in the u.s. term premium at

least over the past decade is the Fed

substantial purchase of long duration

Treasury securities and mortgage-backed

securities in our large-scale asset

purchase programs between 2008 and 2014

these purchases which were concentrated

at the longer end of the US yield curve

took duration out of the market and thus

lower the equilibrium yield required by

investors to hold the reduced supply of

long duration assets estimates of the

cumulative effect of these purchases on

the u.s. term premium span a wide range

with some estimates above 100 basis

points moreover and this is an important

point the global market for sovereign

bonds and currency hedge duration is

tightly integrated and it seems likely

that asset purchase programs and some

other major economies such as Japan in

the euro area and the UK have

contributed as well to reducing the term

premium in the US and of course us L SAP

program slightly contributed to lower

term premiums abroad a third contributor

to a lower u.s. term premium is less

widely appreciated than lower inflation

volatility and the lsat programs and

this third factor reflects the value

that bonds have provided over the past

20 years as a hedge against equity risk

as documented by Campbell syndrome and


and in a later paper by Campbell

Pflueger and visera the empirical

correlation between US bond and stock


change sign in the late-1980s from

positive to negative and here's a paper

here's a chart reproduced from this

their paper in the 1970s and 80s the

sign of the correlation was positive

which implied that in those days bond

and stock returns tended to rise and

fall together in this period bonds

provided a diversification bennet

benefit when added to an equity

portfolio the bond returned baited the

stocks was around point two but not a

hedge against equity risk but since the

late 90s the empirical correlation

between bond and stock returns has

typically been negative and the bond

returned beta to stocks is averaged

about a negative point two this means

that since the late 1990s bond returns

tend to be high and positive when stock

returns are low and negative so that

nominal bonds have been a valuable

outright hedge against equity risk as

salt such we would expect the equilibria

yield on bonds to be lower than

otherwise and certainly relative to the

prior period when the correlation was

opposite as investors should bid up

their price to reflect their value as a

hedge against equity risk now according

to Campbell and co-authors the hedging

value of nominal bonds with a negative

beta to stocks could substantially lower

the equilibrium term premium quoting

from their paper from peak to trough the

realized beta of Treasury bonds has

declined by about 0.6% and has changed

sign according to a simple cap in model

this would imply that the term premium

on a ten-year zero coupon Treasury

should have declined by about sixty

percent of the equity premium let me

give you a concrete example of what

turned out to be the ex post hedging

value of bonds for equity risk in the

global financial crisis in 2008 the

total return on the S&P index was minus

37 percent while the total return on the

on the run 30-year Treasury bonds was

plus 38 percent so a 50/50 portfolio

would have been flat in the great

financial crisis in a 8 now there is

likely no single explanation for the

change in sign of the correlation

between a Calabrian bond and

stock returns in the US and other major

economies and I asked my team at the

board and indeed you see this change in

sign occurs also in Germany in the

United Kingdom we'd be happy to plot it

for Switzerland when we get back

there's no likely single explanation for

this change of sign one recent paper

that does rigorously model the changing

value of nominal bonds as a hedge

against equity risk is the paper by John

Campbell and co-authors I mentioned

earlier this paper develops an estimates

a modern very very sophisticated asset

pricing model in which the sign of the

covariance between equity and bond

returns depends upon the reduced form

correlation between inflation the output

gap the correlation between the policy

rate and the output gap as well as the

persistence of inflation now this paper

is agnostic as to why the reduced form

correlation between inflation and the

output gap and the funds rate in the

output gap both change sign in their

sample which spans the period 1979 to

2011 but the authors do demonstrate that

in their model these reduced form sign

changes are sufficient to generate the

sign change in the correlation between

equilibrium returns that we observe in

the data I myself believe that the

change in u.s. monetary policy that

began in 1979 under Paul Volcker and

that was extended by Alan Greenspan in

the 1990s very likely contributed to the

change in the sign of the correlation

between inflation the output gap and the

pot and the correlation between the

policy rate and the output gap that we

observe in them in the data and

certainly this is a topic that I worked

on with Mark and Geordi years ago these

are the sort of patterns that a simple

model of optimal monetary policy would

produce when starting from an adverse

initial condition in which inflation is

well above the implicit target as was

the case in 1979 in these models high

initial inflation triggers a policy

response for the central bank to push up

the real policy rate well above

inflation in order to push output below

potential via a Phillips curve lowering

inflation towards target

if this policy succeeds ex-post

inflation expectations become anchored

at a new lower level of inflation and

policy can then respond to demand shocks

by adjusting real rates procyclical e

inflation will also tend to be

procyclical with well anchored inflation

expectations if demand shocks dominate

and inflation expectations remain

anchored so let's discuss now some

implications of all this by lowering

expected inflation by anchoring expected

inflation at a low level by contributing

to a reduction in the volatility of

inflation and by contributing to

creating a hedging value of long

duration bonds inflation targeting

monetary policy is lowered equilibrium

bond yields relative to equilibrium

short rates substantially compared with

the experience of the 1970s and 80s but

as I noted earlier during the past

decade equilibrium short rates have

themselves fallen dramatically these two

phenomena taken together have resulted

in sovereign bond yields that are

substantially lower than the pre-crisis

experience and the substantially kloewer

closer to the effective lower bound for

the policy rate than they were before

the crisis but what does this mean for

monetary policy at its most basic level

the answer to this question could depend

on how far the nominal policy rate is

from the effect of lower bound and the

extent to which the term premium on long

duration bonds can become even more

negative than it is a present at least

in the US while I do not have a precise

answer to this question I will confess

that I think it's highly unlikely that

in the next downturn whenever it is the

ten-year Treasury yields will fall by

the 390 basis points we observed between

o 7 and 2016 or even the 360 basis

points that we observed between January

of 2000 and 2003 the reality of low

neutral rates in equilibrium bond yields

has motivated us at the federal reserve

to take a hard look this year at our

monetary policy strategy to

goals and communications practices while

we believe our existing framework has

served us well we believe now is a good

time to step back and assess whether and

in what ways we can refine our strategy

tools and communications practices to

achieve and maintain our goals as

consistently as possible in the world we

live in today now as I have noted before

the review of our current framework is

wide-ranging and we are not prejudging

where it will take us but events of the

past decade highlight three broad

questions that we will seek to answer

with our review the first question is

can the Fed best meet its statutory

objective with its existing strategy or

should it consider strategies that aim

to reverse past misses of the inflation

objective at our September FOMC meeting

we discussed makeup strategies in which

policymakers would promise to make up

for past inflation shortfalls with a

sustained accommodative stance of policy

and tend to degenerate higher future

inflation such strategies provide

accommodation at the ELB by keeping the

policy rate low for an extended period

makeup strategies may also help anchor

inflation expectations at the two

percent objective but the benefits of

makeup strategies dependently on the

private sectors understanding of them as

well as the belief that future policy

makers will follow through on promises

to keep policy accommodative an

advantage of our current framework over

the make up approach is that it has

provided the committee with the

flexibility to assess a broad range of

factors and information in choosing

policy actions and these actions can and

do vary depending upon economic

circumstances in order to best achieve

our goals we are also considering

whether our existing policy tools are

adequate to achieve and maintain our

employment and price stability

objectives or whether our toolkit should

be expanded and if so how because the US

economy required additional support

after the ELB was reached the committee

deployed two additional tools beyond

changes in the federal funds rate

balance sheet policies and forward


the review is examining the efficacy of

these tools as well as additional tools

for easing policy when the ELB is

binding in light of the more recent

experiences of other countries finally

we are focusing on how the committee can

improve the communication of its policy

framework and actions our communication

practices have evolved considerably

since 1994 when the committee first

released a statement after a FOMC

meeting as part of the review we are

assessing the committee's current and

past practices and additional forms of

communication that could be helpful in

terms of process we've heard from a

broad range of interested individuals

and groups in 14 Fed listens events this

year at our july 2019 meeting the

committee began to assess what we've

learned from these events and to receive

briefing from the staff on topics

relevant to the review but we still have

much to discuss at upcoming meetings we

will share our findings with the public

when we have completed our review lately

during the first half of 2020 so to

conclude the economy is constantly

evolving bringing with it new

opportunities and challenges one of

these challenges is how best to conduct

monetary policy in the new world of low

equilibrium interest rates it makes

sense for us to remain open-minded as we

assess current practice and consider

ideas that could potentially enhance our

ability to deliver on the goals that

Congress has assigned to us for this

reason my colleagues and I do not want

to preempt or to predict our ultimate

findings what I can say is that any

refinements or more material changes to

our framework will be aimed solely at

enhancing our ability to achieve and

sustain our objectives

stepping back earlier today speakers at

this conference discussed the challenges

of making monetary policy in an

uncertain and risky environment in my

remarks I've laid out an important

example of the interaction between the

macro economy monetary policy and the

market response to risk the papers you

were about to discuss through the next

two days present cutting-edge research

on the effects and measurement of

and uncertainty and volatility with a

special focus on monetary policy and

market behavior I look forward to

learning from your insights and

encourage your rich discussion over the

next few days and your connected your

continued work on these important topics

thank you for your time and attention

thank you