Janet Yellen gave a speech on July 2. It of course received considerable attention in the financial media.
Over the years, I have dutifully provided translations of speeches by the chairmen of the Board of Governors of the Federal Reserve System — that tiny part of the FED that is technically part of the U.S. government. As far as I know, I am the only financial columnist who provides a translation service out of FEDspeak into English.
Greenspan was a master of FEDspeak. Bernanke preferred to give long, boring summaries, with lots of footnotes, of the recent history of financial events that everyone already knew about. When he did say anything of substance, it usually turned out to be wrong, such as his repeated insistence that there was no housing bubble.
Yellen takes a different approach. She prefers to talk about what the Federal Reserve might do, and really ought to do, but has not yet done. She scrupulously avoids mentioning deadlines. The following observation is clearly the essence of her job as chairman: “Janet Yellen would not be caught dead with a deadline.” This leaves the door open to wiggle room in the future.
All of this confuses the issues. All of this fills up allotted speech time without providing any specifics. This is the FED’s version of “transparency.” Transparency in bureaucratic affairs means this: “provide an illusion to the public that something significant is being revealed, when nothing significant is being revealed.” On the contrary, anything significant is being concealed.
The key to understanding Dr. Yellen’s Chairmanship from this point on is to understand that she is something of a mystic. Imagine an Indian swami in a loincloth, his eyes closed, and his face revealing oneness with the universe. He keeps repeating a mantra. He says: “Om.”
Her mantra is “macroprudential.”
FED Chairmen all correctly assume that no one in the mainstream media will actually spend the time to go through her speeches, point by point, to see if anything of significance is being presented. The message these days is always the same.
1. Before 2008, we didn’t know what we were doing.2. We have learned from our mistakes.3. The economic issues are highly complex.4. The exact nature of economic causation remains a mystery.5. We are working on emergency plans. 6. We have great confidence in these plans.7. These plans have not yet been fully implemented.8. We are not sure when they will be fully implemented.9. We are monitoring the situation.10. There are still important questions to be answered.11. We as yet have no specific answers to any of these questions.12. We are leaving our options open.
Let me show you how this works. She began with the admission of questions.
The recent crises have appropriately increased the focus on financial stability at central banks around the world. At the Federal Reserve, we have devoted substantially increased resources to monitoring financial stability and have refocused our regulatory and supervisory efforts to limit the buildup of systemic risk. There have also been calls, from some quarters, for a fundamental reconsideration of the goals and strategy of monetary policy. Today I will focus on a key question spurred by this debate: How should monetary and other policymakers balance macroprudential approaches and monetary policy in the pursuit of financial stability?
Translation: “The recent crises, beginning in 2008 in New York banking and investment circles, and rapidly spreading all over the world, caught central bankers flat-footed. Nobody saw it coming. Therefore, we are now devoting resources to monitoring all this. This means we require lots more paperwork from bankers.”
In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role.
Translation. “We still have no theory of cause and effect with respect to monetary policy. These issues are ‘not well understood,’ if you get my drift. For a century, the Federal Reserve System has been justified to the public as crucial because it is in charge of monetary policy. Unfortunately, monetary policy is not well understood, so we have pretty much given up on monetary policy as a tool of central planning. We have therefore returned to the tried and true promise of the Progressive movement in 1913: we will regulate the overall economy by regulating the banks, meaning about a dozen large banks. I call this regulatory system, to the extent that it is a system, ‘macroprudential.’ This sounds very scientific. It sounds comprehensive. It sounds prudent. That ought to keep you rubes happy.”
Such an approach should focus on “through the cycle” standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities.
Translation. “That’s what the approach should do. There is no evidence yet that this is what it will in fact do. We will not know that until the next crisis hits. Wish us luck. Your financial future is dependent on us.”
I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability.
Translation. “Yes, I know all about the carry trade: borrow short at rates just above zero, and lend long at rates way above zero. That is what blew up Lehman Brothers in 2008. It could happen again. We will have to change our policy at some point in the future. Since we are buying half of the U.S. government’s annual deficit, putting it all in T-bonds as part of Operation Twist, plus $180 billion in Fannie/Freddie IOU’s, in this, the recovery phase, you can imagine how much we will have to buy when the next recession hits, and the deficit goes back over a trillion a year. Hold onto your seats then, boys and girls.”
Despite these complementarities, 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.
Translation. “We have provided the incentives, but households have ignored them. Households have contracted their debt. The ratio of debt service repayment to household disposable personal income has fallen like a stone. Businesses have been cautious for five years. But the top five banks have cashed in on these incentives like there is no tomorrow — exactly as they did, 2004-2007.”
But such risk-taking can go too far, thereby contributing to fragility in the financial system. This possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment–the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant.
Translation. “Sure, things can go too far. So what? The federal government is running a deficit of half a trillion dollars a year, and we are going to buy over half of it in T-bonds, plus $180 billion of Fannie and Freddie bonds. We are all Keynesians here.”
Although it was not recognized at the time, risks to financial stability within the United States escalated to a dangerous level in the mid-2000s. During that period, policymakers–myself included–were aware that homes seemed overvalued by a number of sensible metrics and that home prices might decline, although there was disagreement about how likely such a decline was and how large it might be.
Translation “We didn’t have a clue that the housing market was a bubble. That’s why Bernanke went public and categorically denied it in 2005. He said it again in 2007. Nobody at the FED said a word in public about the possibility of a decline in housing prices. The word ‘overvalued’ was never mentioned. But I know none of you will look it up, so I’ll get a free pass.”
What was not appreciated was how serious the fallout from such a decline would be for the financial sector and the macroeconomy. Policymakers failed to anticipate that the reversal of the house price bubble would trigger the most significant financial crisis in the United States since the Great Depression because that reversal interacted with critical vulnerabilities in the financial system and in government regulation.