Its the clearest statement yet that the new U.S. central bank chief has made that she does not anticipate using monetary policy to counteract the prices of stocks, bonds or real estate from rising out of line with fundamental values. Doing so, in her estimation, could undercut the Fed's efforts to meet its goal of promoting employment by raising the cost of borrowing for business and consumers looking for home or car loans.
In an International Monetary Fund speech in Washington, Yellen said that monetary policy, such as the Fed's interest rate decisions or quantitative easing, “faces significant limitations as a tool” to address bubbles. Instead, "supervision and regulation needs to play the primary role” in preventing banks from taking on too much risk.
The Fed's regulatory powers, including the ones created by the 2010 Dodd-Frank financial overhaul law, are the best way to ensure systemic stability, according to Yellen. “Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,” she said.
She also acknowledged, however, that the Fed has yet to fully address the possibility of runs in the “shadow banking” system, a central problem in the 2008 crisis. “That is going to be a huge challenge to which I don't have a great answer,” she admitted.
Since before she replaced Ben Bernanke as the top Fed official in February, Yellen has made clear that in dire circumstances, she would consider using the central bank's control of the money supply to prevent a dangerous bubble from forming in a financial market. At her November confirmation hearing, she said that she “would not rule out using monetary policy as a tool to address asset price misalignments, but because it's a blunt tool” she would prefer to rely on the Fed's regulatory powers.
That’s still her view. In response to a question from IMF Director Christine Lagarde, Yellen said, “I’ve not taken monetary policy totally off the table.” She explained that “it’s not a first line of defense, but it is something that has to be in the mix.”
But Yellen apparently sets a very high bar for what constitutes a bubble that would need a monetary policy response from the Fed. She does not see such a bubble now.
“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,” she said, acknowledging at the same time that there are “pockets of increased risk-taking across the financial system” that could become concerns in the future.
Yellen went a step further, and questioned whether it would even have been appropriate to use monetary policy to offset the housing bubble that preceded the 2008 financial crisis. “Such an approach would have been insufficient to address the full range of critical vulnerabilities” in the financial and regulatory systems, she said, adding that although raising interest rates might have slowed housing price increases, they also would have increased unemployment and hurt consumers' balance sheets.
An internal Fed study reported by the Economist found that the losses to raising rates to crimp a hypothetical asset bubble would be more damaging than those that would result if the Fed instead kept rates low, leading to financial instability and a second financial crisis 10 years later on.
The question of whether and how central banks should act to calm asset markets has become an important topic of debate. Over the weekend, the Bank of International Settlements, the international organization of central banks, published a warning that “euphoric” asset markets stoked by low interest rates present a risk to developed countries.
Furthermore, some officials, such as Minneapolis Fed President Narayana Kocherlakota and former Obama adviser Larry Summers, have raised the possibility that the economy cannot generate sufficient consumer demand to grow without the Fed keeping rates low, thereby risking financial instability.
Yellen acknowledged that she’s worried about that scenario, saying in response to a question from Lagarde that “if it is correct that equilibrium real rates in the U.S. and Europe will be lower going forward than they have been historically, we will have to worry” about financial excesses.