The equity risk premium prices the risk taken by investors in purchasing equities rather than risk-free debt, and gives a measure of the risk aversion of investors. It is equal to the total expected return on common stocks discounted by the return on US Treasuries. “The recent importance of movements in equity premiums and asset bubbles suggests the need to better understand and integrate these concepts into the models used for policy analysis,” Greenspan said.
He also claimed that recent history suggests monetary tightening that deflates stock prices without depressing economic activity has often been associated with subsequent increases in the level of stock prices.
For example, stock market indexes rose following a more than 300 basis point rise in the federal funds rate in the twelve months ending in February 1989. Then in February 1994, the Fed raised the federal funds target 300bp, and as soon as this tightening programme was completed, stock prices resumed their ascent.
During the recent technology sector bubble, the federal funds rate was raised by 150bp between mid-1999 and May 2000, but generally stock prices remained relatively high.
Alluding to the dynamics of equity risk premiums and bubbles, and the limitations of existing models that underpin tests of the effectiveness of monetary policy, Greenspan cautioned: “The results from models whose internal structure cannot successfully replicate key features of cyclical behaviour must be interpreted carefully.”