The Federal Reserve was slow to understand how the collapse of the housing market would lead to a profound financial crisis, Chair Janet Yellen acknowledged Wednesday, arguing that even if it had acted more aggressively the crisis could not have been prevented.
In a speech at the International Monetary Fund’s Washington’s headquarters, Yellen said that the Fed’s mission of monetary policy via higher or lower interest rates could offer only limited help in holding back the crisis.
“A review of the empirical evidence suggests that the level of interest rates does influence housing prices, leverage ... but it is also clear that a tighter monetary policy would have been a very blunt tool,” Yellen said in a speech on monetary policy and financial stability.
Fed critics blame the central bank’s policy of low interest rates for allowing households and investment banks alike to take on too much risk and debt _ effectively giving them the rope with which they hanged themselves. Had the Yellen and her colleagues more aggressively raised the Fed’s benchmark lending rates, they argue, it would have raised mortgage rates and slowed the scorching home-price appreciation that proved unsustainable.
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Yellen pushed back on that argument Wednesday.
“Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment,” she said.
Unlike most central banks, the Fed has a dual mission. It seeks to both prevent inflation from eroding the purchasing power of ordinary Americans while promoting full employment in the economy. Higher interest rates might have slowed the bubble, she suggested, but at the cost of high joblessness.
Higher interest rates would have done little to slow the risk-taking in the financial sector ahead of the 2008 crisis and Great Recession, she said, noting that the reliance by banks on debt and short-term financing continued growing through the middle of 2007, even as the Fed was raising interest rates.
The tougher post-crisis approach by regulators, including stronger rules on underwriting and requirements for banks to hold more capital in reserve to buffer against shocks, have helped build a more resilient, safer financial sector, Yellen insisted.