Yellen: Fed Not In The Bubble Popping Business

by: Financial Sense

By Cris Sheridan

If you think stocks are in a bubble and the Fed should start raising rates, well, the last two speeches from Fed Chair Yellen certainly paint a different view.

Speaking on June 18th at the most recent FOMC press conference, Yellen first made it clear that rates would be kept near zero for a "considerable time" (see story).

Then just recently, speaking at the IMF, Yellen also pushed back against calls that the Fed should ultimately raise rates to prevent unstable bubbles from forming.

Here she says:

[M]onetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment."

Not only did Yellen argue against using interest rates as a first line of defense against bubbles, but also pointed to a range of studies that conclude tighter monetary policy wouldn't have prevented the last bubble either. Instead, she says, "macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods…"

After putting to rest the idea that raising rates in the past, present, or future is the best way to fight bubbles, she then goes on to say that this also represents the consensus view of most central banks around the globe. After reviewing a number of recent examples, Yellen states:

[I]t seems clear that monetary policymakers have perceived significant hurdles to using sizable adjustments in monetary policy to contain financial stability risks. Some proponents of a larger monetary policy response to financial stability concerns might argue that these perceived hurdles have been overblown and that financial stability concerns should be elevated significantly in monetary policy discussions. 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."

Put simply, the Fed is unlikely to raise rates if there's another stock market or housing bubble UNLESS doing so won't damage their more important goals of employment and inflation.

Finally, Yellen moves away from the view that central banks should be concerned about identifying bubbles and popping them, but more towards building a "resilient financial system" for when they do explode:

At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. 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."

Yellen concludes her speech by saying that she doesn't "presently see a need for monetary policy to deviate…in order to address financial stability concerns," nor are there currently any systemic threats from too much leverage with lenders.

Moral of the story: If employment and inflation are still a concern and there's a bubble brewing in the market, don't expect the Fed to raise interest rates to stop it.