Risk-Centric Macroeconomics.

• Author: Caballero, Ricardo J.

Financial markets are central banks' gateway to the economy. After the global financial crisis and the Great Recession, the Federal Reserve came to the rescue of financial markets with an aggressive mix of conventional and unconventional policies. During the COVID-19 shock, the Fed implemented similar policies even though this shock did not originate in financial markets. In both instances, asset prices rose rapidly in response to policy interventions. Rising asset prices were not a side effect of monetary policy, but instead a central pillar of the recovery strategy. Today, anticipation of the Fed raising rates has roiled financial markets and resulted in a decline in asset prices that is not just collateral damage, but a central component of Fed strategy to reduce aggregate demand and rein in inflation. Since central banks reach the economy through financial markets, understanding their policy actions requires a framework in which central banks closely interact with markets to achieve their objectives. In several recent papers, we develop a risk-centric macroeconomic framework to shed light on the complex links between monetary policy, financial markets, and business cycles.

Our framework builds on the observation that the productive capacity of an economy generates two related absorption problems. Figure 1 illustrates them: a goods-absorption problem emphasized in macroeconomics (top row) and a risk-absorption problem emphasized in finance (bottom row). Aggregate asset prices (financial conditions) provide a bridge for spillovers across the two rows. In particular, asset prices are determined in risk markets, but affect aggregate demand. Higher stock and home prices increase consumer wealth and spending. Higher bond prices (lower interest rates) reduce the cost of capital and increase investment and spending on durables. Financial frictions strengthen this link: lower rate spreads (or higher collateral values) increase spending by the constrained firms and households.

In our framework, as in practice, the central bank reaches the economy through financial markets. The central bank's objectives--to close the output gap and stabilize inflation--are in the top row, but its tools are in the bottom row. The central bank steers aggregate demand by influencing aggregate asset prices through both conventional and unconventional policies. Our framework is useful for understanding both why and how central banks affect asset prices.

Risk-Premium Shocks, Speculation, and Market Interventions

Our first paper addressing these issues establishes our risk-centric framework and shows that financial market phenomena such as time-varying risk premia and financial speculation can induce or exacerbate aggregate demand recessions. (1) To illustrate the key mechanisms in our model, consider a period of high asset prices, such as the run-up to the financial crisis and the Great Recession. Suppose asset valuations decline, perhaps because investors recognize risks that they previously overlooked and therefore demand a greater risk premium. The macroeconomic effect of this shock depends on the central bank's response. If the central bank is unconstrained, it cuts the interest rate enough to stabilize asset prices. This stabilizes aggregate demand and shields the economy from the riskpremium shock. However, if the central bank is constrained, for example by an effective lower bound on nominal interest rates, then the risk-premium shock...