Few subjects are more important for central bankers than the efficiency and stability of our financial system. The term "financial instability" is often poorly defined. Some argue that financial instability occurs when imperfections or externalities in the financial system are substantial enough to create significant risks for real aggregate economic performance. Others argue that financial stability is potentially absent, or that financial instability is on the horizon, when they perceive that some important set of financial asset prices seem to have diverged sharply from fundamentals. Finally, many observers have used the term "financial instability" to describe their perception that market functioning seems to have been significantly distorted or impaired. Regardless of the definitions used for financial instability, they lead us to a strong interest in ensuring that our financial infrastructure is robust and that our supervisory operations are sound and up-to-date.
Ironically, our interest in financial stability seems to have increased in recent years even as real (that is, inflation-adjusted) variability in economic aggregates seems to have decreased. Since 1985, the volatility of real growth in gross domestic product (GDP) has been only about half of what it was during the preceding twenty-five years. In addition, as shown in a number of papers, the volatility of many components of GDP and of other measures of aggregate economic activity also declined sharply between these periods.
The leading explanations of the moderation are that (1) economic shocks have been milder; (2) inventory management has improved; (3) financial innovations such as improved risk assessment and risk-based pricing have made credit more widely available, even during economic downturns; and (4) monetary policy has been better.
The moderation in aggregate economic volatility seems somewhat understandable. But why, then, the seemingly greater concern these days about financial market instability? This anxiety appears to be driven by three factors: First, some asset prices, such as housing prices, seem to be high by historical standards. Given the substantial decline of stock prices beginning in 2000, many observers worry that greater boom or bust cycles in some asset prices could be the "flip-side" of the moderation of real economic volatility during recent decades.
Asset prices are the key channel through which monetary policy is transmitted to the real economy. Moreover, because asset prices embody the expectations of forward-looking investors, they might contain information of value for the policy-setting process. But from the Federal Reserve's perspective, asset prices must ultimately be seen through the
continued on p. 6