By Steven Beckner

DENVER (MNI) – Federal Reserve Vice Chairman Janet Yellen gave no
real hints about what kind of monetary policy shift, if any, she will
support early next month in her anxiously awaited first speech as
Chairman Ben Bernanke’s top deputy Monday.

Yellen, in lengthy remarks prepared for delivery to the National
Association for Business Economics’ annual convention, did offer the
observation that an accommodative monetary policy “could provide the
tinder” for excessive leverage and risk taking in the financial system.
But it was not clear that she was issuing a contemporary warning about
what might happen if the Fed makes monetary policy too easy.

She also said that the Fed would find it difficult currently to
offset any additional credit constraint that were to occur if higher
capital standards were imposed too quickly. Hence, she noted, the new
Basel III capital requirements are being phased in over a period of
years.

Yellen, who succeeded Don Kohn as Fed Vice Chairman on Oct. 4, is
expected to play an important role when the Fed’s policymaking Federal
Open Market Committee meets Nov. 2-3 to revise its quarterly, three-year
economic forecast and decide whether or not to provide additional
monetary stimulus.

The former president of the San Francisco Federal Reserve Bank did
comment on the severity of the post-crisis economic environment, saying
that “the recovery has been agonizingly slow” and that “we are still
suffering from the shock of an epic financial disaster.”

However, Yellen largely steered clear of the monetary policy issues
that will face the FOMC, preferring instead to talk about the lessons of
the financial crisis for “macroprudential policy” — the set of
regulations and monitoring systems being put in place to recognize and
preempt future episodes of “systemic risk.”

Yellen is widely regarded as a “dove” so concerned about the
possibility of deflation that she will readily support a resumption of
quantitative easing. But some of her comments at least give pause to
making facile assumptions at this stage.

In the course of talking hypothetically about the interaction of
monetary policy and macroprudential policy and how monetary policy can
affect systemic risk, she said, “monetary policy can affect systemic
risk through a number of channels.”

“First, monetary policy has a direct effect on asset prices for the
obvious reason that interest rates represent the opportunity costs of
holding assets,” she illustrated. “Indeed, an important element of the
monetary transmission mechanism works through the asset price channel.”

“In theory, an increase in asset prices induced by a decline in
interest rates should not cause asset prices to keep escalating in
bubble-like fashion,” she continued. “But if bubbles do develop, perhaps
because of an onset of excessive optimism, and especially if the bubble
is financed by debt, the result may be a buildup of systemic risk.”

Second, Yellen said “recent research has identified possible
linkages between monetary policy and leverage among financial
intermediaries.”

“It is conceivable that accommodative monetary policy could provide
tinder for a buildup of leverage and excessive risk-taking in the
financial system,” she said, again seeming to speak in a general,
theoretical vein — not necessarily commenting on the current policy
environment.

Yellen went on to say that “macroprudential interventions may also
have macroeconomic spillovers.” For example, she said “research suggests
that rigorous enforcement of supervisory standards for capital following
the real estate-related loan losses of the early 1990s may have slowed
the economy?fs recovery from the recession.”

That’s why the Basel III doubling of capital requirements is being
phased in, she said. “The implementation of tighter standards over a
multi-year period should mitigate the concern that the macroprudential
policies we are putting in place to control systemic risk will unduly
restrict the availability of credit, thereby retarding economic
recovery.”

“In this case, as it should, the implementation of macroprudential
policy is taking account of spillovers that monetary policy, at least
now, cannot easily offset,” she added.

Yellen said, “Herculean efforts” will be required by the Fed and
other authorities to strengthen financial surveillance and curtail
systemic risk. Both rules and discretion will be needed, she said, and
“it is necessary for monetary policy to take into account any
macroeconomic effects resulting from macroprudential policy and vice
versa.”

“This separate-assignments approach to formulating macroprudential
and monetary policy has merit both in theory and practice,” she went on.
“But I want to be careful not to push the argument for separation too
far.”

She warned that “situations may arise in which the Federal Reserve,
in its conduct of monetary policy, might not be able to fully offset the
macroeconomic effects of macroprudential interventions.”

“This scenario could happen because of the zero bound on interest
rates or monetary policy lags,” she elaborated. “In such circumstances,
it makes sense for macroprudential policy to take macroeconomic effects
into account.”

“By the same token, I would not want to argue that it is never
appropriate for monetary policy to take into account its potential
effect on financial stability,” she continued. “Regulation is imperfect.
Financial imbalances may emerge even if we strengthen macroprudential
oversight and control.”

While monetary policy must play a role in containing systemic risk,
Yellen cautioned that “monetary policy cannot be a primary instrument
for systemic risk management.”

“First, it has its own macroeconomic goals on which it must
maintain a sharp focus,” she said. “Second, it is too blunt an
instrument for dealing with systemic risk. All the same, I cannot
unequivocally rule out the possibility that situations could emerge in
which monetary policy should play some role in reining in risk-taking
behavior.”

Yellen said quantitative indicators of financial market behavior
will need to be employed in the effort to monitor and control systemic
risk to prevent excessive leverage and risk-taking in the future.

“We will gather an array of data on risk spreads, credit flows and
volumes, asset prices, debt and leverage, markets, and institutions,
including detailed, often proprietary, microdata on balance sheets and
data from such markets as those for over-the-counter derivatives and
repos,” she said.

She said, “surveillance is likely to concentrate on key factors in
the buildup of systemic risk such as…the accumulation of credit and
funding risk on the balance sheets of systemically important
institutions and throughout the financial system, the correlation of
risk among financial market participants, and the extent of counterparty
exposures.”

“Of course, we must also keep a close eye on broad credit and asset
market conditions,” she continued. “One strand of surveillance will
involve watching variations of risk and term spreads of bonds and other
securities relative to historical norms.”

Yellen said, “narrow risk spreads and risk premiums may be a
harbinger of excessive risk-taking by investors.”

“Another strand will focus more directly on measuring credit flows
and exposures to credit risk,” she added. “If overall credit growth is
extraordinarily rapid, it may be a sign that financial institutions are
taking greater risks onto their balance sheets.”

She acknowledged that “leverage is impossible to measure
perfectly,” but she said “still, real-time indicators of the leverage of
financial intermediaries would help identify where we are in a credit
cycle.”

“For example, we can look at the marginal leverage of new borrowing
by examining data on collateral haircuts,” she said. “We may also
monitor data on repo market activity and haircuts to spot
vulnerabilities relating to maturity mismatches. This information can be
crosschecked against firm- and sector-level data on credit risk
exposure.”

As for whether the Fed can identify asset price bubbles, Yellen
said, “bubbles present systemic danger when major financial institutions
use leverage to finance investment in risky assets that they hold on
their balance sheets.”

And she said, “the systemic risk is multiplied when the asset
bubble is accompanied by a credit bubble that fuels highly leveraged
investment.”

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