Is Janet Yellen Repeating Past Policy Mistakes?

by: Desmond Lachman

Federal Reserve Chair Janet Yellen did not keep the Bank for International Settlements (BIS) waiting long for her assessment of its monetary policy recommendations. Since barely two days after the BIS issued its warning that US and global financial markets had become largely disconnected from underlying economic fundamentals, in an important speech today at the International Monetary Fund, Mrs. Yellen dismissively argued that there was no need for US monetary policy to deviate from its present course to focus on issues related to financial market stability.

At the heart of the difference of view between the BIS and Mrs. Yellen is the question as to what might be the appropriate role of the central bank with respect to the emergence of asset price bubbles. In a manner reminiscent of former Fed Chairman Alan Greenspan in the run up to the bursting of the US housing and credit market bubble in 2007, Mrs. Yellen subscribes to the view that it is not the role of policymakers to identify, much less to pop bubbles in the early stages of their formation. Rather what policymakers should do is to use macro-prudential policies advisedly to ensure that the financial system is resilient enough to withstand the bursting of bubbles should that actually occur.

To her credit, Mrs. Yellen at least acknowledges that there currently are pockets of increased risk taking across the financial system, which if that was to continue might necessitate a more vigorous macro-prudential approach. In particular, she does agree that both corporate bond spreads and expected volatility in some markets have fallen to very low levels, while terms and conditions in the leveraged loan market have eased significantly as investors have reached for yield. She also acknowledges that this suggests that some investors might be underappreciating the potential for losses and volatility going forward. However, in her view these considerations do not argue in favor of using interest rate policy for purposes of ensuring financial market stability.

A problem with Mrs. Yellen’s approach is that rather than using interest rate policy as a means to remove the proverbial punchbowl before the financial market party really gets going, her forward guidance on interest rate policy gives the markets a green light to keep on partying. This raises the real risk that the asset price bubbles across credit and equity markets, which she now seems to acknowledge might be forming, become all the more pronounced. It also raises the risk that she might be underestimating the impact of the bursting of these bubbles, especially on those parts of the financial system that are beyond her regulatory reach.

Only time will tell whether the BIS was right in now sounding the alarm again, as it was prior to the bursting of the US housing bubble, or whether Mrs. Yellen was right in being as sanguine as she appears to be today about financial market risks. Sadly, however, the clues all seem to be pointing in the direction of the BIS being right in its concern about the current frothiness of US and global asset markets.