Federal Reserve Bank Chairman Janet Yellen has begun to articulate a prudent approach to monetary policy.
Before raising interest rates, Yellen recommends a macroprudential approach that will focus on proper supervision and regulation of the financial system — one that alleviates systemic financial risk and increases global economic stability.
Key ingredients include maintaining more appropriate levels of capital to absorb potential losses, especially in times of stress and strong credit expansion, and exercising restrictions on trading that promote greater transparency.
The macroprudential mechanism will rein in the growth of credit, ward off unsustainable risk taking and maintain financial and economic stability. It has the same general effect as raising interest rates by diminishing demand for borrowing funds. However, simply raising interest rates might not prevent inordinate risk taking that can severely disrupt the market and create long-term volatility and uncertainty.
This methodology is in opposition to that of the Bank of International Settlements (BIS), the Basel, Switzerland-based global central bank. In its recent annual report, the BIS suggested that monetary policymakers should quickly raise interest rates to deflate high prices in equities, corporate bonds and other financial assets, such as junk bonds and collateralized loan obligations.
Despite a recent Labor Department report that unemployment dipped to 6.1 percent in June, down from 7.5 percent a year ago, Yellen cites low levels of labor force participation, slow wage growth and a lackluster housing market as evidence that inflation poses little risk and interest rates need to remain at the current low levels to promote employment and economic activity.
This October, the Fed expects to end its bond-purchasing program. Since 2008, total assets held by the Fed, which includes loans, bonds and other assets, has expanded approximately 375 percent, from roughly $900 billion in 2008 to more than $4.3 trillion today. Less purchasing of these assets will place downward pressure on prices and upward pressure on interest rates.
After exhausting the macroprudential supervision and regulatory measures, Yellen believes interest rate adjustments can be utilized to stabilize price movements and optimize employment. Exercising this option prematurely might disrupt the orderly allocation of resources and market-clearing mechanisms.
In her view, raising interest rates at this time could undermine growth in employment and general economic activity. She suggests rate increases begin toward the middle of 2015, with a 1 percent point rise by the end of that year.
This approach seems appropriate for these times. Proper capital ratios and transparent trading must occur if this policy is to succeed.
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