U.S. Markets closed

Janet Yellen speaks on monetary policy and financial stability

Surbhi Jain

Why Janet Yellen supports a macroprudential economic approach (Part 1 of 7)

The interconnection between the monetary policy and financial stability

While addressing her audience on Wednesday, July 2, at the 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, in Washington, DC, Janet Yellen, the current Chairwoman of the Federal Reserve, spoke on the interconnection between the monetary policy and financial stability.

Interconnections between macroeconomic and financial stability have been apparent in the past in the Latin American debt crisis, the Mexican peso crisis, and the East Asian financial crisis. However, the key question remains—how should monetary and other policymakers balance macroprudential approaches and monetary policy in the pursuit of financial stability? Yellen takes this opportunity to answer this relevant question for her audience.

Yellen recognizes limitations of the monetary policy

While recognizing that the monetary policy faces significant limitations as a tool, Yellen believes that a macroprudential approach to supervision and regulation needs to play the primary role. For example, bringing about financial stability through adjustments in interest rates tends to increase the volatility of inflation and employment.

Taking the case of the current scenario, she talked about a key risk that arises from low-interest rates—a monetary policy tool being used to enhance liquidity in the financial system. Low interest rates often heighten the incentives of financial market participants to reach for yield and take on risk, eventually leading to financial instability.

As interest rates are lowered by the Fed, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. Certain exchange-traded funds (or ETFs) like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM), the Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN), are designed to protect the investors against interest rate risk caused by inflation.

Yellen talked about financial instability. She discussed how financial stability and price stability goals are complementary to each other.

Continue to Part 2

Browse this series on Market Realist: