For example, Barbara Rossi and co-authors find that while risk fell sharply after the great financial crisis, Knightian uncertainty – situations in which people might be unable to assign correct probabilities to future outcomes – remained persistently high even after the end of the crisis.11 In these cases, investors still have to make a decision, and judgement – often based on current observables – is usually the only basis they have. Whatever the ultimate reasons, does it matter if the inflation risk premium is low? There are two sides to the discussion. From a monetary policy perspective, what matters most is that inflation expectations remain at levels consistent with price stability. At the margin, a low inflation risk premium is positive as it signals increased confidence in the central bank’s ability to achieve its inflation aim. But from a financial stability perspective, and here I again refer to previous work presented in the ECB’s Financial Stability Review, a low inflation risk premium may be a matter of concern if it indicates complacency about future adjustments.12 In this case, a reappraisal of investors’ view about future risks to global inflation may cause a correction of global risk premia, in particular in an environment of historically low volatility, as you can see on my next slide. Oil prices may be a potential catalyst. ECB internal research finds that energy price shocks have become considerably more persistent lately, which could fool investors into believing that they are bound to stay at current moderate levels in the foreseeable future.
At face value, this would suggest that the repricing of interest rate expectations at the short end of the US curve has not been passed through to long-term rates. This interpretation is incorrect, however. Indeed, and this is my second point, the broad stability of the ten-year yield masks two sharply diverging developments: a marked fall in the term premium – the yellow area – and an appreciable repricing by markets of the expected future path of short-term interest rates – the dark orange area. You can see this clearly on the slide. Put simply, if it weren’t for the parallel fall in the term premium, ten-year Treasuries would trade some 50 basis points above their January 2017 levels and we wouldn’t be having a discussion about flattening. US long-term yields have resisted upward pressure only because of a considerable re-compression of the term premium. Only shortly after the UK’s referendum on EU membership in summer 2016 was the US ten-year term premium more negative than it is today. This allows for one preliminary conclusion but begs one question. The conclusion is that markets seem sanguine about the prospects for the US, and probably also for the global, economy. Judging from the average expected short-term rate over the next ten years, the markets appear to have shaken off some of the pessimism that caused them to tread very carefully over the past few years. Past and currently expected policy rate changes are predicted to last.