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The Federal Reserve’s reliance on macroprudential policy

In a recent speech Federal Reserve Chair Yellen has emphasized the economic cost of making financial risk a key consideration of monetary policy. While accommodative and non-conventional monetary policy may boost risk taking, enhanced regulation should secure financial system resilience and contain excesses. Only when macroprudential policy cannot achieve that goal should monetary policy step in. That time would not be now.

“Monetary policy and financial stability”, Janet L. Yellen
2014 Michel Camdessus Central Banking Lecture,2 July 2014.

The below are excerpts from the speech. Cursive lines and emphasis have been added.

The three principles of financial risk policy

“I see three key principles that should guide the interaction of monetary policy and macroprudential policy in the United States.

  • First, it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability… Key steps along this path include…[i] full implementation of Basel III, including new liquidity requirements; [ii] enhanced prudential standards for systemically important firms… [iii] expansion of the regulatory umbrella to incorporate all systemically important firms…[iv] the institution of an effective, cross-border resolution regime…and [v] consideration of regulations…to limit leverage in sectors beyond the banking sector…
  • Second, policymakers must…be realistic about the ability of macroprudential tools to influence [evolving financial risk] developments. The limitations of macroprudential policies reflect the potential for risks to emerge outside sectors subject to regulation, the potential for supervision and regulation to miss emerging risks, the uncertain efficacy of new macroprudential tools such as a countercyclical capital buffer, and the potential for such policy steps to be delayed or to lack public support. Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability
  • [Third,] policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy. “

The case for reliance on macroprudential policy

Monetary policy has powerful effects on risk taking. Indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments.”

“Risks to financial stability within the United States escalated to a dangerous level in the mid-2000s. During that period, policymakers…were aware that homes seemed overvalued by a number of sensible metrics…What was not appreciated was how serious the fallout from such a decline would be for the financial sector. ”

Substantially tighter monetary policy in the mid-2000s…would have been insufficient to address the full range of critical vulnerabilities… A tighter monetary policy would not have closed the gaps in the regulatory structure …would not have shifted supervisory attention to a macroprudential perspective; and…would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector. ”

“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.”

“In my assessment, 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 to address [financial system] vulnerabilities.”

The macroprudential toolkit

“If macroprudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macroprudential tools are likely to be most effective… I find it helpful to distinguish between tools that primarily build through-the-cycle resilience against adverse financial developments and those primarily intended to lean against financial excesses…

  • Resilience against runs can be enhanced both by stronger capital positions and requirements for sufficient liquidity buffers among the most interconnected firms. An effective resolution regime for SIFIs can also enhance resilience by better protecting the financial system from contagion… Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical…
  • Macroprudential tools can, in some cases, be targeted at areas of concern. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional loss-absorbing capacity within the financial sector during periods of rapid credit creation while also leaning against emerging excesses. The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions.”

An assessment of current financial system risk

“Accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector. ”

“Overall, nonfinancial credit growth remains moderate, while leverage in the financial system, on balance, is much reduced. Reliance on short-term wholesale funding is also significantly lower than immediately before the crisis, although important structural vulnerabilities remain in short-term funding markets.”

“Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns… I do see pockets of increased risktaking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach… we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and…we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.”


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