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

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“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.”

According to Yellen, tighter monetary policy would have been a blunt tool that would have done more harm by way of higher unemployment without substantially mitigating the financial vulnerabilities.

But the Fed chief acknowledged that even with the current accommodative monetary policy, there is financial complacency surfacing in the system. The Fed has maintained its target for the benchmark federal funds rate – the key interbank overnight borrowing rate — near zero since 2008.

“Corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may under-appreciate the potential for losses and volatility going forward,” Yellen said. “In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly.” Though this is not a real risk at present, “credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate.”

Financial stability could be ensured by taking steps like the full implementation of Basel III, increasing the capital requirements for financial institutions to absorb losses, enhancing prudential standards for systemically important firms, having risk-based capital requirements, and placing tighter provision requirements on firms that rely heavily on short-term wholesale funding.

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