Yellen and the Reach for Yield

Federal Reserve Vice Chair Janet Yellen, speaking at the IMF “Rethinking Macro Policy II” conference, notes that Fed policy is intended, at least in part, to increase risky-taking behavior:

Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let’s remember that the Federal Reserve’s policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy.

Certainly some reflation of asset prices is helpful in healing household balance sheets and thus   But she and other realize that it can go too far:

…Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don’t see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.

It would be hard not to make this conclusion given the role of asset bubbles in the dynamics of the last two business cycles.  Still, what is the right policy response?  Yellen:

However, I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense.

The center of gravity at the Fed remains wary of using interest rates to temper suspected asset bubbles, excessive leverage, etc.  They prefer the idea of using supervision and regulation.  One little problem though:

The Federal Reserve has been working with a number of federal agencies and international bodies since the crisis to implement a broad range of reforms to enhance our monitoring, mitigate systemic risk, and generally improve the resilience of the financial system. Significant work will be needed to implement these reforms, and vulnerabilities still remain.

No, we don’t have the tools in place.  And, I would add, regulators will be continuously playing catch-up on the regulatory front.  Consequently, the ball might fall in the monetary policy court:

Thus, we are prepared to use any of our many instruments as appropriate to address any stability concerns.

Which leaves me a thinking that although the Fed might not want to use monetary policy to blunt any suspected financial stability risks, they may find themselves in a place where they believe they have no other choice because alternative tools are not available.

Not an immediate issue, but one to keep an eye on.  The Fed is not likely to be so dismissive of financial stability risks the next time around.

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About Tim Duy 348 Articles

Tim Duy is the Director of Undergraduate Studies of the Department of Economics at the University of Oregon and the Director of the Oregon Economic Forum.

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