Is the Federal Reserve Really Our Economy’s Main Line of Defense?

Source: Craig Hatfield / Flickr Creative Commons

“Financial regulation should be the main line of defense,” Federal Reserve Chair Janet Yellen said during a conversation with IMF Managing Director Christine Lagarde on Wednesday. “I’m not taking monetary policy totally off the table,” she added. “It is something that has to be actively in the mix.”

Having said so, for the most part during her speech, Yellen maintained that financial stability had come as a result of sound macro prudential policy and that monetary policy on its own has limitations in fulfilling the objective of bringing financial stability.

“Efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment,” Yellen said in her address at the International Monetary Fund in Washington. “As a result, I believe a macro prudential approach to supervision and regulation needs to play the primary role.”

Yellen responded to the longstanding criticism that the financial crisis perhaps could have been averted if the Fed had maintained a tighter interest rate policy in the mid-2000s and burst the housing market bubble before it took down the entire financial system.

“A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some systemically important financial institutions (SIFIs) and markets to escape comprehensive supervision,” Yellen said. “A tighter monetary policy would not have shifted supervisory attention to a macro prudential perspective, and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.”