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Janet Yellen just delivered the most significant speech yet in her still-young Federal Reserve chairmanship. It doesn't necessarily send any startling signals about what the Fed will do next month or even next year. But it tells us a great deal about how she will deal with new risks on the horizon from financial bubbles.
Yellen stakes out her position in about as clear a language as you'll see from a central banker: She believes that it would most likely be a bad idea to raise interest rates to fight financial excesses. Her focus, crucially, is not on preventing Wall Street from having ups and downs, but on making sure that those ups and downs don't bring economic disaster.
This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a "bubble," and whether policy makers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical.
As global financial markets continue their five-years-and-counting rally, urged along by policy from the Fed and other central banks, worry has been rising that the seeds are being sown for the next crisis. The Bank for International Settlements, the organisation based in Basel, Switzerland, that is effectively the central bank for the central banks, argued just that in a major new report that essentially accuses its own members of fecklessness in their easy-money policies.
The leader of the most powerful of those central banks isn't buying it, and her speech is a shot across the bow arguing that higher interest rates are not the answer to whatever financial excesses one sees.
"Monetary policy faces significant limitations as a tool to promote financial stability," Yellen said in an event at the International Monetary Fund in Washington. "Its effects on financial vulnerabilities … are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment."
The Fed is focused on making sure that even if markets in, say, leveraged buyout loans were to take a dive from current frothy levels (this is the one market Yellen herself mentioned as showing signs of excess), the impact wouldn't ripple through banks and other financial institutions and cause a broad downturn for the economy. They are doing this by demanding that banks hold more capital, and that they constantly test their portfolios to ensure they could weather a downturn, among other steps.
But the most interesting parts of Yellen's speech were not so much her cataloguing of specific tools the Fed is using to try to address financial risk, many of which watchers of the central bank's communications have heard about before. It was in her use of recent experiences in the United States and abroad to explain why she thinks interest rate policy is a poor substitute for good regulation.
First, many Fed critics view too-low interest rates during the mid-2000s as a crucial factor behind the housing and credit bubble that popped so disastrously beginning in 2007. Sure, higher interest rates in 2003 to 2006 might have slowed the rate of home price growth, Yellen concedes. But, she adds, "the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period … but the job losses and higher interest payments associated with higher interest rates would have directly weakened households' ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly."
Moreover, she argues higher interest rates would have done nothing to address some important points of vulnerability in the pre-crisis financial system, such as excessive leverage in the world's largest banks.
She doesn't absolutely rule out using interest rate policy as a tool to combat financial excess, while making clear it is a less than optimal option. But with her speech on Wednesday, Yellen is putting banks and everyone else in the financial world on notice: The Fed is not going to protect you from making mistakes. It is just going to try to ensure that if you do make them, the rest of us won't pay the consequences.
Yes, the Yellen Fed will raise interest rates one day, (projections from the policy makers point to that day being in 2015). But they will probably do so because the United States economy is getting back on its feet, not to lean against the winds of markets.
©2014 The New York Times News Service
