Alan Greenspans Views on Risk Premiums: Humphrey-Hawkins Testimony (2/26/97)
"The Federal Reserve will be weighing these influences as it endeavors to help extend the current
period of sustained growth. Participants in financial markets seem to believe that in the current benign
environment the FOMC will succeed indefinitely. There is no evidence, however, that the business
cycle has been repealed. Another recession will doubtless occur some day owing to circumstances that
could not be, or at least were not, perceived by policymakers and financial market participants alike.
History demonstrates that participants in financial markets are susceptible to waves of optimism,
which can in turn foster a general process of asset-price inflation that can feed through into markets
for goods and services. Excessive optimism sows the seeds of its own reversal in the form of
imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized,
the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as
they can amplify the upswing. As you know, last December I put the question this way: "...how do
we know when irrational exuberance has unduly escalated asset values, which then become subject to
unexpected and prolonged contractions ...?"
We have not been able, as yet, to provide a satisfying answer to this question, but there are reasons in
the current environment to keep this question on the table. Clearly, when people are exposed to long
periods of relative economic tranquility, they seem inevitably prone to complacency about the future.
This is understandable. We have had fifteen years of economic expansion interrupted by only one
recession--and that was six years ago. As the memory of such past events fades, it naturally seems
ever less sensible to keep up one's guard against an adverse event in the future. Thus, it should come
as no surprise that, after such a long period of balanced expansion, risk premiums for advancing
funds to businesses in virtually all financial markets have declined to near- record lows.
Is it possible that there is something fundamentally new about this current period that would warrant
such complacency? Yes, it is possible. Markets may have become more efficient, competition is more
global, and information technology has doubtless enhanced the stability of business operations. But,
regrettably, history is strewn with visions of such "new eras" that, in the end, have proven to be a
mirage. In short, history counsels caution.
Such caution seems especially warranted with regard to the sharp rise in equity prices during the past
two years. These gains have obviously raised questions of sustainability. Analytically, current
stock-price valuations at prevailing long-term interest rates could be justified by very strong earnings
growth expectations. In fact, the long-term earnings projections of financial analysts have been
marked up noticeably over the last year and seem to imply very high earnings growth and continued
rising profit margins, at a time when such margins are already up appreciably from their depressed
levels of five years ago. It could be argued that, although margins are the highest in a generation, they
are still below those that prevailed in the 1960s. Nonetheless, further increases in these margins
would evidently require continued restraint on costs: labor compensa- tion continuing to grow at its
current pace and productivity growth picking up. Neither, of course, can be ruled out. But we should
keep in mind that, at these relatively low long-term interest rates, small changes in long-term earnings
expectations could have outsized impacts on equity prices.
Caution also seems warranted by the narrow yield spreads that suggest perceptions of low risk,
possibly unrealistically low risk. Considerable optimism about the ability of businesses to sustain this
current healthy financial condition seems, as I indicated earlier, to be influencing the setting of risk
premiums, not just in the stock market but throughout the financial system. This optimistic attitude has
become especially evident in quality spreads on high- yield corporate bonds--what we used to call
"junk bonds." In addition, banks have continued to ease terms and standards on business loans, and
margins on many of these loans are now quite thin. Many banks are pulling back a little from
consumer credit card lending as losses exceed expectations. Nonetheless, some bank and nonbank
lenders have been expanding aggressively into the home equity loan market and so-called "subprime"
auto lending, although recent problems in the latter may already be introducing a sense of caution."