By Mohamed A. El-Erian
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Over the weekend, I reread remarks that U.S. Federal Reserve chair Janet Yellen made last week at the International Monetary Fund and also read the transcript of her conversation with Christine Lagarde, the International Monetary Fund's managing director.
The IMF event brought together a virtual who’s who of the international economic and financial community, and in one of her most significant policy speeches to date, Yellen seized the opportunity to address head-on some of the major questions confronting modern central bankers. Many of these center around the burden of trying to restore, almost singlehandedly, economic growth, more dynamic job creation, price stability, and durable market stability.
There are seven major takeaways from Yellen's IMF speech. They collectively signal that the Fed will maintain a gradual policy approach for now. Markets, conditioned to expect strong and steadfast monetary support from the Fed, welcome that stance. But Yellen's statements also point to the need for a delicate transition from policy-induced growth to more organic economic growth. If that transition is mishandled, it would trigger renewed financial and economic instability.
First, Yellen recognizes that we could well be in a world of steady-state interest rates that, in both nominal and inflation-adjusted terms, are lower than what historical experience would suggest.
Second, such rates, as Yellen noted, can “heighten the incentives of financial market participants to reach for yield and take on risk.” Indeed, she added, “such risk-taking can go too far, thereby contributing to fragility in the financial system.”
Third, financial stability cannot be divorced from the pursuit of economic well-being, because “a smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment.”
Fourth, this situation places even greater importance on the effectiveness of macro-prudential policies as “the main line of defense” against financial excess in the marketplace.
Fifth, while progress has been made in strengthening crisis prevention through better macro-prudential measures, more is needed at the policy level. With that in mind, Yellen stated that she “has not taken monetary policy totally off the table as a measure to be used when financial excesses are developing." Since macro-prudential tools "have their limitations,” monetary policy should be "actively in the mix” even though it is “not a first line of defense.”
Sixth, central banks have to continue to think imaginatively about additional tools they can deploy to bolster the economy and maintain financial stability given the constraints they face in using interest rates as an effective macroeconomic tool.
Finally, Yellen noted that it would help if other global policymakers also pursued reforms needed to unleash the productive power of Western economies.
Yellen's important statements last week confirm that the Fed will maintain its current gradual policy approach: namely, tolerating financial excesses in the hope that that will ultimately lead to more dynamic economic growth. As such, the Fed will continue to brush aside the risk of future financial instability in favor of near-term economic gains when it thinks about interest rates and issues policy guidelines.
Investors, however, shouldn't think that Yellen's comments represent a permanent state of affairs at the Fed. The institution is already well aware of bubble-like conditions in certain financial markets and it recognizes that there is only so much macro-prudential regulations can do to limit systemic risk.
All of this reminds me of an important observation that Jeremy Stein, a former Fed governor, made in a May speech at New York University about the current policy paradigm, one with which the Fed is wrestling and markets would be well advised to keep on their radar screens too.
Stein pointed out that current Fed gradualism has married effectively with investor expectations to produce low volatility in financial markets. That will remain a happy marriage only if it leads to solid economic growth and doesn't throw off the collateral economic damage that excessive risk-taking can entail.
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