Federal Reserve Chair Janet Yellen said Wednesday that the nation’s central bank should refrain from using interest rates to combat financial excesses except in extreme cases. Instead, she called for targeted measures to pop bubbles as they arise and a stronger safety net to prevent them in the first place.
Central banks around the world are grappling with the question of how to prevent another global financial crisis — and some have argued it will require a fundamental rethinking of the way those institutions operate. In fact, critics both inside and outside the Fed have raised concerns that years of easy-money policies could be seeding the next bubble by encouraging investors to pile on risk.
Yellen sought to dispel those fears Wednesday. In her speech at the International Monetary Fund, she said that no change in monetary policy is necessary to correct any current financial imbalances. And in most cases, she said, the economic toll from raising interest rates would outweigh the benefits of curbing investors’ appetite for risk.
“I think my main theme here today is that macroprudential policies should be the main line of defense,” Yellen said.
Macroprudential tools have become the buzzword in shoring up the country’s financial system. Measures include the Fed’s ongoing efforts to establish higher capital requirements for banks and guidelines for winding down large firms at the heart of the financial system.
But Yellen also said that work to reform some areas -- particularly some forms of short-term lending and money market mutual funds -- “has, at times, been frustratingly slow.” Yellen also suggested additional regulations may be needed to curb risks in the wholesale funding markets.
These changes could help the country’s increasingly complex and interconnected financial system withstand the inevitable cycles of boom and bust, Yellen said.
“Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,” she said.
But when trouble does strike, Yellen said the Fed could “lean against the wind” by temporarily increasing capital buffers, as outlined in a new global agreement on banking standards known as Basel III. She also cited the Fed’s bank stress tests as a method for ensuring that financial institutions plan for the unexpected.
Yellen argued that those weapons would likely be more effective than the blunt tool of monetary policy. To make her point, she rebutted a common criticism that the Fed primed the stage for the Great Recession by waiting too long to raise interest rates, allowing home prices to rise unabated and incentivizing investors to take excessive risks.
The Fed chair conceded that policymakers “failed to anticipate” the ensuing global financial crisis but also argued that monetary policy would have been “insufficient” to address its causes. Higher rates would not have beefed up regulation or increased the transparency of the exotic new financial instruments at the heart of the crisis -- or the firms that helped generate them.
In fact, Yellen said that raising rates would likely have caused greater unemployment, which would likely have led to more people defaulting on their debts.
“A more balanced assessment, in my view, would be that increased focus on financial stability risks is appropriate in monetary policy discussions, but the potential cost, in terms of diminished macroeconomic performance, is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time,” she said.
Yellen did acknowledge that there may be extraordinary circumstances in which raising interest rates may be necessary to stabilize the financial system. The blunt but widespread impact of a rate hike would have the ability to help stem speculation in sectors the Fed may not even know about. But Yellen offered no framework for making that call.
“Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability,” she said.
The debate over financial stability is part of the fundamental rethinking of the role of central banks in the wake of the global recession. But Yellen pointed out that though much of the discussion has focused on the trade-offs between curbing risks and central banks’ traditional mandates of maximum employment and price stability, those goals complement one another more often than not.
“A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability,” she said.
IMF Managing Director Christine Lagarde questioned Yellen after the speech about the global consequences of the Fed’s decisions. Early hints last year that the central bank was preparing to back away from its easy-money stance led to turmoil in the markets, particularly in developing economies. Officials in those countries, along with the IMF, have called for more communication and consideration from the Fed.
On Wednesday, Yellen said some — but not all — of the disruption could be traced to the central bank. Most of the ripple effects of the Fed’s actions are positive, she said, as stronger growth and stable prices in the United States help boost the global economy.
But Yellen also attempted to assure the international community that the central bank understands their concerns.
“Generally, these are not beggar-thy-neighbor policies,” she said. “We certainly strive to avoid harm in generating spillovers.”