Yellen says regulations best tool for financial excesses

WASHINGTON — Federal Reserve chief Janet Yellen said Wednesday the nation’s central bank should not combat financial excesses by raising interest rates except in extreme cases. Instead, she called for targeted regulations that could pop bubbles as needed and a stronger safety net to prevent them in the first place.

The speech marked Yellen’s most detailed response so far to criticisms — from within and without the central bank — that the Fed’s years of easy-money policies may be sowing seeds of the next crisis by encouraging investors to take on excessive risk. Speaking at the International Monetary Fund, Yellen pushed back against those arguments, stating that current pockets of risk within the financial system do not warrant a change in monetary policy.

Yellen did acknowledge that there may be extraordinary circumstances in which raising interest rates may be an appropriate tool. She offered no framework to guide that decision.


‘‘Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability,’’ Yellen said.

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Yellen focused instead on what are known as macroprudential tools that aim to strengthen the foundations of the financial system. She also outlined several targeted responses the Fed and other regulators could take during times of crisis to shore up any remaining areas of weakness.

The Feds ongoing work to establish higher capital requirements for banks and guidelines for winding down large firms at the heart of the financial system are among the key macroprudential measures. But Yellen also said that work to reform some areas — particularly the triparty repo market and money market mutual funds — ‘‘has, at times, been frustratingly slow.’’ Yellen also suggested additional regulations may be needed to curb risks in the wholesale funding markets.

Such reforms could help the country’s increasingly complex and interconnected financial system to withstand the inevitable cycles of boom and bust, Yellen said. ‘‘Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,’’ she said.

But when crisis does strike, Yellen said, the Fed could ‘‘lean against the wind’’ by temporarily increasing capital buffers, as outlined in a new global pact on banking standards known as Basel III. She also cited the Fed’s bank stress tests as an example of how the central bank is ensuring that financial institutions plan for the unexpected.


Yellen argued that those weapons would likely be more effective than the blunt tool of monetary policy. To make her point, she rebutted a common criticism that the Fed primed the stage for the Great Recession by waiting too long to raise interest rates, allowing home prices to rise unabated and encouraging investors to add risk.

Yellen conceded that policymakers ‘‘failed to anticipate’’ the ensuing global financial crisis but also argued that monetary policy would have been ‘‘insufficient’’ to address the problems that caused it. Higher rates would not have beefed up regulation or increased the transparency of the exotic new financial instruments at the heart of the crisis — or the firms that helped generate them.

Yellen said raising rates would likely have caused more unemployment, which would likely have led to more people defaulting on their debts.

‘‘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,’’ she said.

The debate about financial stability is part of the fundamental rethinking of the role of central banks after the global recession. But Yellen said much of the discussion has focused on the trade-offs between curbing risks and central banks’ traditional mandates of maximum employment and price stability.


‘‘A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment,’’ she said. “A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty.’’