Janet Yellen has mounted a forceful defence of the US Federal Reserve’s decision to keep monetary policy loose in the face of soaring asset prices, arguing there was no need to increase interest rates to tackle financial instability because the central bank has other tools at its disposal.
In a signal of how the Fed intends to prevent a repeat of the 2008 crisis, its chairwoman suggested the central bank is more interested in having a resilient financial system that can cope when asset bubbles burst than it is in popping them through rate rises.
That means there is little chance of an increase in interest rates to head off exuberant stock or bond markets, suggesting that investors will be allowed to inflate and collapse asset classes as long as the underlying financial system is strong enough to withstand any shocks.
“I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns,” said Ms Yellen.
“That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach.”
A macroprudential approach would involve using non-monetary policy tools designed to manage the safety of the financial system as a whole.
Ms Yellen’s remarks run counter to a recent warning from the Bank for International Settlements, which said that rates should rise now in order to control financial speculation. They also show how the US has diverged from other countries such as Norway and Sweden, which have kept monetary policy tighter than they otherwise would to boost financial stability.
Instead, the Fed’s main focus is tough regulation of banks, which is likely to be bad for US bank profitability.
“Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,” said Ms Yellen.
She called for new measures to address risk in short-term wholesale funding markets, such as reverse repurchase arrangements, where market players borrow against the security of assets such as Treasury bonds.
Ms Yellen said there should be minimum margin requirements – the amount of equity a borrower should have – for such transactions.
Ms Yellen also made clear the Fed could act against financial excesses, in particular by varying the requirements of its stress tests, which require banks to show they have enough capital to deal with a range of possible shocks.
“The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions,” she said.
I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach
Monetary policy is too blunt a tool to tackle financial risks unless they become extreme, she said, because there would be a cost in terms of higher unemployment and below target inflation.
“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.
The Fed chairwoman acknowledged some signs of over-optimism in financial markets recently but said they had not developed in a way that threatened financial stability.
“For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may under-appreciate the potential for losses and volatility going forward,” she said.
“In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly.”
But to date, she said, that had not become a systemic threat. “Broad measures of credit outstanding do not suggest that non-financial borrowers, in the aggregate, are taking on excessive debt,” said Ms Yellen, suggesting the Fed does not see an immediate need for tough action.