Trader Talk

Can the Fed and Janet Yellen control bubbles?

Janet Yellen, chair of the U.S. Federal Reserve.
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Fed Chair Janet Yellen, in a speech at the International Monetary Fund, gave a defense of the Fed's policies and tried to answer critics who say the Fed's policies of low rates have increased the risk of financial market instability and may be leading to the creation of asset bubbles.

She made it clear she doesn't want to use interest rates to control perceived bubbles that may have or will develop. Yellen's concerned that just raising rates would be too blunt an instrument, that it would increase the volatility of inflation and employment.

She's likely right, but it's not clear her alternative will work.

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To deal with bubbles that may develop, she would rather use "macroprudential regulation."

What does that mean? It means the Fed believes it can control bubbles by regulating financial institutions and financial instruments.

How do you do that? Well, let's look at stocks. You think stocks are too high? You think a bubble maybe developing? The answer, the Fed might say, is not to raise interest rates. Instead, let's raise margin requirements!

You think exotic derivatives like collateralized loan obligations (CLO) are a problem? Don't raise rates, raise capital requirements on them. Or raise capital requirements on the banks that enable them!

On the surface, this sounds sensible. The idea is you create specific targeted actions instead of just raising rates on everyone.

The problem is, there is a certain amount of hubris in this assumption, because it is not at all clear that the Fed can control bubbles via regulation.

There's a bigger problem: It doesn't really address the root problem. Why do bubbles develop? In the case of real estate and stocks, there is certainly evidence that low rates for abnormally long periods of times are a factor in the creation of those bubbles.