One needs to go back to the Bretton Woods era to get volatility levels as low as at present. 2  BIS Review 124/2006  BIS Review 124/2006  3  Of course the reduction in the volatility of returns – and the lower compensation for future volatility embedded in risk premia – is responding to some real changes in the world. You might break down sources of uncertainty about future returns into three components: macroeconomic risks, financial risks and risks in the broader environment. Macroeconomic volatility has fallen considerably over the last decade in many economies [Chart 5]. In the real economy, greater flexibility in labour and product markets, especially openness to foreign competition through trade and immigration, has enabled smoother adjustment to shocks. On the price side, central bank independence and inflation targeting have contributed to greater price stability. There is also greater depth and sophistication and fewer rigidities in financial markets. Innovation has created a variety of products enabling more and better risk transfer by financial market players and greater choice for end-investors. Greater financial market flexibility can support macroeconomic stability by keeping credit and liquidity available during periods of stress. But risks in the broader environment haven’t gone away. Threats from ecological or biological disasters, fraud, political conflict and terrorism seem as high as ever. And these are risks we have identified. As ever there may be some significant “unknown unknowns”.
Because the contribution to growth from inventory investment can be quite volatile on a quarter-to-quarter basis, the growth in real final sales probably provides a better sense of the state of economic activity than does the GDP figure. Moreover, when one digs deeper, the fundamentals supporting domestic demand look quite sturdy. For example, consumer spending has been well-supported by real income gains and rising household net worth. Household balance sheets do not appear over-extended. The household debt service burden is low, the household saving rate is not low relative to household net worth, and household credit growth has been slow. Housing fundamentals are solid as well. Decent payroll gains have supported household formation over the past year and mortgage rates remain low. Housing prices are rising and the constraint on growth in residential investment now appears to be more on the supply side, as building contractors struggle to mobilize the resources needed to construct more homes. The National Association of Home Builders’ index rose in October to the highest level  BIS central bankers’ speeches  1  since late 2005. While the housing indicators will likely continue to be volatile on a month-to-month basis, I expect the gradual improvement in the housing sector to continue. Also, the international outlook appears less problematic than it did just a few months ago. Although substantial questions remain about the Chinese growth outlook and the consequences of lower commodity prices for major commodity-exporting countries, we have seen two important positive developments.