Inaugural Michel Camdessus Central Banking Lecture on Financial Stability’, at the IMF
CHRISTINE LAGARDE: Oh, my goodness. Madam Chairman, you have impressed us enormously with a rich, dense, very informative and very candid read — your read of the current situation and how monetary and macroprudential — monetary policy and macroprudential tools could be used in sequence, in parallel, in different circumstances. And I would like to, maybe following the Stradivarius analogy of Michel, to stay loyal to (our man ?) today, what would you say? Would you say that macroprudential tools are second fiddle to the main Stradivarius of monetary policy? Or would you say that, depending on circumstances, macroprudential tools become the premier violon and have to deal with the issues as a first line of defense?
JANET YELLEN: Well, I think my main theme here today is that macroprudential policies should be the main line of defense, and I think the efforts that we’re engaged in in the United States but all countries coordinating through the — through Basel, through the Financial Stability Boards — the efforts that we are taking to globally strengthen the resilience of the financial system: more capital, higher quality capital, higher liquidity buffers, stronger and — arrangements for central clearing of derivatives that reduce interconnectedness among systemically important financial institutions, strengthening of the architecture of payments and clearing system dealing with risks we see in areas like tri-party repo.
All of these efforts — and particularly focusing on the resilience of the most systemically important firms through SIFI surcharges and other measures — higher leverage ratios. I see this as the core step that we need to take in the United States and globally to create a safer and sounder financial system. And if we’re able to do that, reducing also the reliance on wholesale funding, if the system does experience shocks, it will be better able to deal with it.
I would also put resolution planning which we’re engaging in actively as among those measures. And, you know, as I mentioned, I think cyclical policies and sector-specific policies that we’re seeing many emerging markets take steps that can be used, particularly when we see problems developing in housing or a particular sector. These are really promising.
I don’t think we yet understand how they work. When they can be effective, how we should use them. I hope this will be an area for the IMF and for us of active research so we can better deploy those tools, capital — countercyclical capital charges.
But I think importantly, I’ve not taken monetary policy totally off the table as a measure to be used when financial excesses are developing because I think we have to recognize that macroprudential tools have their limitations. And there may be times when monetary policy does need to be adjusted or deployed to lean against the wind. So to me, it’s not a first line of defense, but it is something that has to be actively in the mix.
MS. LAGARDE: Right. And if you — if you’re using your first line of defense, do you think that this is likely — not now but sort of in more (calm ?) possibly and in more medium-term times, would you — would that help us get away from this zero lower bound environment in which monetary policy is currently a bit stark without being negative about the — being stuck — words that I’m using. But whether it’s here or whether it is in the U.K. or in the euro area, we are faced with that issue.
With the exploring of negative interest rates, as is the case now in — by the ECB. Do you believe that the sort of constant use of those macroprudential tools are likely to move us out of that direction?
MS. YELLEN: So it is remarkable to see how many countries have been affected by the zero lower bound. It’s something that for most of my career would have seemed frankly unimaginable. And often, it has been the case that these episodes have occurred in the aftermath of a crisis that impacted the financial system whether it’s in Japan or here in the United States.
So, you know, I think it will be helpful if we can strengthen the financial system. Such huge adverse shocks are less likely. Still it is a real possibility.
And for example, the work that we’ve done with the standard kind of macroeconomic models we use inside the Federal Reserve, looking at the incidents of shocks that have occurred, there is a real possibility — there remains a real possibility that we could continue to be hit by the zero lower bound.
And I think, you know, we’ve had recently many discussions of secular stagnation or the notion that for some period of time, whether it’s because of slower productivity growth or headwinds from the financial crisis or demographic trends that so-called equilibrium real interest rates may be at a lower level than we’ve seen historically.
And that’s one of the factors that I think will be important in determining how frequently a negative shock could push economies against the zero lower bound. So if it is correct that equilibrium — (inaudible) — rates in the United States and globally may be lower going forward than they have been historically, I think we will have to worry about these episodes more often.
And, you know, of course often there are other tools besides monetary policy, and sometimes monetary policy bears the brunt — I mean, in recent years it has borne the brunt of responding. I think if countries had greater fiscal scope, if they had more room for the use of fiscal policy than many countries have now, there would be a larger toolkit that could be used to respond to the zero lower bound.
MS. LAGARDE: Well, the toolkit of the moment seems to include more structural reforms than fiscal space, although this is — the situation is improving slightly.
On the sort of (tendential ?) lower interest rates, our research department that is headed by Olivier Blanchard, who is around somewhere, has done similar work to the one that you’re alluding to, and we point to that direction as well.
MS. YELLEN: And you’ve — so that’s –
MS. LAGARDE: One — let me take you one circle further. You’ve beautifully demonstrated the efforts that have been undertaken from a macroprudential point of view in terms of the universe that you have under your jurisdiction. But this universe, being restricted and well supervised as it is, has generated the creation of parallel universes. And, you know, I’m just thinking of you, Janet, with the toolbox with all the attributes that you have — what can you do about the shadow banking at large? And, you know, I’m not giving it any dismissive connotations. It just happens that there have been developments of alternative funding mechanisms and financing mechanisms that are outside the realm of central bankers. What can be done about them in order to make sure that there is no creation of significant risk threats out there which are not covered by macroprudential tools?
MS. YELLEN: So I think you’re pointing to something that is an enormous challenge. And we simply have to expect that when we draw regulatory boundaries and supervise intensely within them, that there is the prospect that activities will move outside those boundaries and we won’t be able to detect them. And if we can, we won’t be — we won’t have adequate regulatory tools. And that is going to be a huge challenge to which I don’t have a great answer. But as we think about tools that we can use to address systemic risk, I think it’s particularly useful to focus on those that have the potential to control risks not only among regulated institutions but also more broadly.
And that’s one reason that in the speech I gave, I mentioned margin requirements and, you know, limit — that can serve to limit leverage not only within the banking system but more broadly, by any institution –
MS. LAGARDE: That would use the (clearing ?) system.
MS. YELLEN: — hedge fund, an unregulated — right, that would be borrowing — using short-term financing to take on leverage positions. Because this is the type of tool that might have wide –
MS. LAGARDE: Universal. Yeah.
MS. YELLEN: — more universal effect. I’ll tell you also, we have developed — as many, you know, as you have and as many central banks have — very active monitoring programs to try to be on the lookout for what will cause the next crisis. Hopefully, many, many years in the future, but –
MS. LAGARDE: We’ll both be retired by then.
MS. YELLEN: I think — I certainly hope so. But you know, what are the new threats? And, you know, we’re trying to look for those and to be attentive to them and, you know, particularly to look outside the regulatory perimeter to see where threats are emerging. But this is a — this is a real challenge, I think, for all of us.
MS. LAGARDE: We share exactly the same concern and we try to — because we look at the horizon and we know where they –
MS. YELLEN: (What ?) could happen.
MS. LAGARDE: — could be the traditional risks based on history.
But what I’m obsessed about is what do we not know from history and that will arise and that will be the risk of tomorrow.
MS. YELLEN: Yeah. I think we have a much more active program of monitoring for those risks and –
MS. LAGARDE: Yeah.
MS. YELLEN: — you know, than we did before the crisis.
MS. LAGARDE: Let me take — you’ve taken examples from Canada, Switzerland and a few other countries. You know, I’d be remiss not to address the issue of spillover. We are an institution that is concerned by 188 countries; they are the members. And we are doing as much research as we can to identify the spillovers from monetary policies and macroprudential tools used as you have described them.
We have seen an episode of strong spillovers between, say, May 2013 and August 2013. I know it’s not directly in your mandate to worry about the spillovers, it’s in mine. (Laughter.) And we compare our notes and — on a friendly basis.
But what — how do you perceive them? How do you integrate them in your — in your way of thinking? And are you attentive as well to what we are working on, which is the study of the spillbacks from the spillover? And for those who are not so much in tune with our spill-spill business, the spillovers I think is widely understood as the consequences outside of domestic base of decisions made in terms of monetary policy in that domestic base. The spillbacks is the consequences of the spillovers as they bounce back to the domestic markets where the decisions were originally made. And I’m sure that you pay attention to it.
MS. YELLEN: So we certainly do pay attention to spillovers, although the Fed — and this is true of most central banks — the mandates that we’re given by our — by Congress or the relevant legislatures tend to focus on domestic goals.
We certainly strive to avoid harm in generating spillovers when we use monetary policy, and of course, we are very much affected by the global environment. And so the spillbacks to which you refer are central in our analysis of our own economy and what the impact of our policies would be.
I mean, I think if you look at U.S. monetary policy generally, given — of course, there are spillovers. I mean, in global financial markets that — where capital flows are as large as they are in the global economy today and financial markets are so interconnected, of course, there are spillovers and there is no denying that.
But I think, you know, when you’ve seen significant impacts on, say, emerging market economies from capital flows, I think most studies — ours and I think of other researchers — would suggest that there are a multiplicity of factors that are causing it, of which movements in global interest rates would be only one.
So for example, when we instituted QE2, which generated in that period after that there were capital inflows into many emerging markets. I mean, there were other factors also: stronger growth in the emerging markets, I think, was an important factor. And shifts in risk attitudes among investors globally that are not necessarily driven by monetary policy.
But I guess the other point I would make is that the studies that we have done — and I believe this would be consistent with the IMF’s analysis — would suggest that when the United States, as important as we are in the global economy — when we adopt policies to — in pursuit of price stability and full employment, given our importance as a purchaser of goods from other countries, generally, these are not beggar-thy-neighbor policies. We’re not mainly affecting foreign countries by pushing down, say, with expansionary policy, our exchange rate, to their detriment.
When our economy expands, we buy more, and on balance, I think the spillovers are not negative, they’re typically positive.
But you did refer specifically to the episode a year ago — and of course we did see before there had been any real change –
MS. LAGARDE: Right.
MS. YELLEN: — in monetary policy, but a shift in communications about future monetary policy, a very pronounced jump in interest rates. And for some countries — and I think they were typically emerging markets with greater vulnerabilities — there were pronounced capital –
MS. LAGARDE: Currency, yeah.
MS. YELLEN: — outflows that put pressure on currencies, caused those countries to tighten monetary policy. And obviously those were disruptive. You know, I think it was –
MS. LAGARDE: Just to give you an example because Michelle Bachelet was here exactly where you are yesterday, and she was reminding me that at that time the currency in Chile went up by 30 percent. Now, it sequently went down a bit, but it had immediate and strong effects on those countries. New Zealand is another point and case.
MS. YELLEN: You know, I think there, in part, what was happening is that traders had built up positions that were premised on unrealistic expectations about interest rate paths and about the appropriate level of volatility. And it wasn’t just a shift in monetary policy, but a rapid unwinding of carry trade and leverage positions that had built up that caused that damage.
You know, I pledged often and will continue, we will try to conduct our monetary policy, to communicate about it and to conduct it in a manner that is understandable to financial markets to avoid the kinds of surprises that could cause jumps in interest rates that cause such capital flows. You know — you know, to some extent — to some extent, I think — I think such spillovers are really unavoidable in a situation in the global capital markets. I don’t know if you would share this assessment, but my own assessment is that most emerging markets do have much stronger financial systems than they had at the time of the crisis that Michelle had to intervene in because of –
MS. LAGARDE: And it’s because they went through the crisis with the support of Michelle and his (sic) team that they felt a lot stronger afterwards, that’s for sure.
MS. YELLEN: Yes. And all the things that were put in place that — the kinds of shocks that we may see or spillover is — as hopefully the global economy recovers and we’re in a position to be able to tighten monetary policy, I wouldn’t assume that this is going to go badly. And I can just say that we will do everything on our side to make sure that it goes smoothly.
MS. LAGARDE: Well, thank you so much for this commitment to it. Certainly, the — there are representatives of the emerging market economies in the room and I’m sure that they are particularly interested in your views as to how we can best — you can best communicate and they can best anticipate so as to limit the volatility risk that arises from that. I will ask you a financial question before we wrap up because I know that we are pressed for time. Michelle referred to Napoleon Bonaparte who said that the central banks should be independent, but not too much.
MS. YELLEN: (Laughs.)
MS. LAGARDE: With that enlarged responsibility in a way –
Well, purposely I changed a little bit. (Laughter.) Monetary policy, macroprudential tools to be used for financial stability, your dual mandate in a way of both employment and growth — are you independent? (Laughter.)
MS. YELLEN: Well, I think we are independent and appropriately so in the conduct of monetary policy. Congress has established the goals the goals that we’re to pursue. And I think this is true in most countries that there’s not goal independence, but there is independence about how to carry out monetary policy.
And there’s an awful a lot of research that suggests that macroeconomic outcomes are better when central banks have the ability to decide how to use their tools. They have to explain them. They have to be accountable. We’re accountable to Congress. And I think that is very important.
Sometimes when central banks take on financial stability mandates, it becomes harder. And I don’t think independence is appropriate in absolutely every sphere of conduct that central banks become involved in. So I think it’s really the conduct of monetary policy where independence is important.
We had the experience during the crisis of putting in place a very large number of liquidity programs and when central banks become involved in those kinds of lender of last resort activities. For example, the lines between what should a central bank do and what’s the responsibility of government can become blurred.
MS. LAGARDE: Right.
MS. YELLEN: And, you know, these are times when I think the activities of central banks can become quite controversial. And one of the things that we did during the crisis to try to clarify what’s the dividing line, what are we supposed to do, what is the line a central bank shouldn’t be dragged over, or if it is, that the fiscal authority should clearly be taking responsibility.
We actually had a kind of accord with Treasury that was signed. It kind of indicated we may use our balance sheet to lend, but we shouldn’t be taking on credit risk. And to the extent we do, it’s the responsibility of the government.
But with cooperation and becomes very natural, the lines do get blurred and there is a potential threat to central bank independence. But I think it is important.
MS. LAGARDE: But from a monetary policy, there is complete independence.
MS. YELLEN: From a monetary policy, there — right. Released tool independence.
MS. LAGARDE: Well, Chairman Yellen, as a token of our appreciation, I would like to hand over to you a little book which celebrates actually the 70th anniversary of the IMF and tells the story of how it all started back 70 years ago plus one day, because the anniversary was actually yesterday of the beginning of the IMF.
You’ve been a fantastic speaker –
MS. YELLEN: Thank you so much.
MS. LAGARDE: — you’ve been a terrific partner in this venture. And I look forward to continuing working for you.
MS. YELLEN: As I do too.
MS. LAGARDE: Thank you so much. (Applause.)..."