Failure, they say, is an orphan, and the financial crisis is no different.
In a speech on Wednesday morning at an International Monetary Fund conference, Federal Reserve Chair Janet Yellen argued that the low-interest-rate policy that the Fed maintained throughout the 2000s did not contribute to the financial crisis.
“It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s,” Yellen said. “At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities” facing the country at the time.
Yellen instead argued that raising rates during the run up to the crisis would have led to higher unemployment without getting to the core issues facing the financial system, which included the use of exotic and poorly understood derivatives and poor risk management on the part of large, systemically important financial institutions. Yellen also referred to a body of empirical studies that have shown that higher interest rates wouldn’t have been an effective tool at fighting the real estate bubble, unless they were raised to such a degree as to cause unacceptable levels of unemployment.
Yellen argued that, instead, the central bank should have focused on using regulatory tools like limits on short-term funding and requirements for banks to hold higher levels of capital in order to fight dangerous bubbles and to make banks healthy enough to survive.
The takeaway for market participants is clear: this speech is a doubling down on Yellen’s promise to keep interest rates low for a long time. Despite the fact that Fed officials like James Bullard and Charles Plosser have been publicly arguing for higher interest rates, it’s clear that the Fed chair doesn’t see any reason to raise rates before the end of next year, at the earliest.
Yellen also made clear that she believes that the Fed should engage in vigorous regulation of the financial system. But Yellen did not say what exactly should be done about financial risks that fall outside the purview of the central bank, what’s known as the “shadow” banking system. When asked how—if not through monetary policy—the Fed could contain risks in shadow banking, Yellen said, “That is going to be a huge challenge to which I don’t have a great answer.”