While some pockets of risk in financial markets exist, Federal Reserve Chair Janet Yellen said Wednesday she does not see the need for monetary policy to shift in order to address financial instability.
“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,” Yellen said in a speech prepared for the IMF’s inaugural Michel Camdessus Central Banking Lecture, named for the fund’s former managing director.
“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,” she continued.
One risk Yellen outlined: Corporate bond spreads, “as well as indicators of expected volatility in some asset markets,” which have fallen to low levels, suggest “some investors may underappreciate the potential for losses and volatility going forward,” she said.
In addition, she said, “terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a ‘reach for yield’ in the face of persistently low interest rates.”
Despite these risks, Yellen said, “To date, we do not see a systemic threat from leveraged lending. She added the Fed is “mindful of the possibility” credit provision could accelerate, and “borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate.”
Therefore, it’s important the U.S. central bank monitors “the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.”
But she doesn’t see a need to shift monetary policy right now for the purposes of systemic stability, in part because the goals of the financial stability and the Fed’s focus on price stability and full employment are complementary.
“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.
Despite these complementarities, “monetary policy has powerful effects on risk taking,” she said acknowledging she is “mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk.”
But this reach for yield “does not obviate the need for monetary policy to focus primarily on price stability and full employment – the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant.”
Another reason to focus on macroprudential tools instead of shifting monetary policy, Yellen said, is the blunt nature of monetary policy tools.
“Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment,” she said pointing to studies that conclude tighter monetary policy during the mid-2000s “might have contributed to a slower rate of house price appreciation.”
Instead, Yellen said, “I believe a macroprudential approach to supervision and regulation needs to play the primary role.”
“Such an approach should focus on ‘through the cycle’ standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities,” she said.
Specifically, additional moves to strengthen macroprudential tools would be completing the transition to “full implementation” of Basel III, enhancing prudential standards for systemically important firms, and tighter prudential buffers for firms reliant on short-term wholesale funding.
Yellen also called for the expansion of “the regulatory umbrella” to incorporate all SIFIs, the institution of “effective, cross-border resolution regime” for such firms, and consideration of regulations, “such as minimum margin requirements for securities financing transactions, to limit leverage in sectors beyond the banking sector and SIFIs.”
In opening remarks, IMF Managing Director Christine Lagarde said “the crisis was a stark reminder that price stability is not always sufficient for greater economic stability. So, should central banks have a financial stability objective?” she asked.
She also said the crisis “has galvanized a broad effort to reform the global regulatory framework,” much work still remains to be done. “How will financial regulation and the new structure of the financial system affect the functioning of monetary policy, domestically and abroad?”