Given the debate over whether tighter monetary policy could have prevented the housing market collapse, understanding Federal Reserve Chairwoman Yellen’s views on the use of monetary policy to control asset bubbles has important implications for the future behavior of the U.S. central bank.
In a speech today to the International Monetary Fund, Chairwoman Yellen made the following three remarks:
"...Monetary policy faces significant limitations as a tool to promote financial stability.”
"I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns…the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. But such risk-taking can go too far, thereby contributing to fragility in the financial system."
"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."
The above comments, taken together, imply that while monetary policy will not be the main tool for promoting financial stability, the Chairwoman will not hesitate to use policy as a tool to control risk-taking if conditions merit. In this manner, she preserves the option to use policy to “prick” asset bubbles, even while acknowledging the relative costs of such “blunt” policy in the form of higher unemployment and the “modest” mitigation of balance sheet risks:
"A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble. Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. 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."
Instead, Chairwoman Yellen suggests that “macroprudential policies” would better address financial stability issues, and that key measures—such as the implementation of Basel III, maintaining minimum margin requirements for securities financing transactions, strengthening oversight of the U.S. shadow banking system (including designation of some nonbank financial firms as “systemically important institutions”) and changing bank capital regulations—would all go a long way toward building financial resilience.
"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 policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical."
Why is this speech relevant for today? Precaution is warranted given the “pockets of increased risk-taking across the financial system,” noted Yellen. “Such an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach.”
As such, market participants would be wise to monitor several of the factors consistent with increased risk-taking on the part of individuals and institutions, including:
Corporate bond spreads and expected volatility indicators, which have fallen to low levels in some asset markets, suggesting that some investors may underappreciate the potential for losses and volatility going forward.
Terms and conditions in the leveraged-loan market, which have eased significantly (even as “to date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers…are taking on excessive debt.”)
Access to credit, as credit provision could accelerate and borrower losses could rise unexpectedly sharply, with leverage and liquidity in the financial system deteriorating.
While we don’t see any near-term departure in the Fed’s policy, look for more open discourse on the degree of financial markets risk; Yellen is hoping that like herself, other policymakers will “clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.”