Federal Reserve Chairwoman Janet Yellen warned Friday that one negative byproduct of an improving economic outlook could be more dramatic market movements as the U.S. central bank cautiously moves toward raising short-term interest rates for the first time since the financial crisis.
“This normalization could lead to some heightened financial volatility,” Yellen warned in text prepared for a speech at the Banque de France in Paris on Friday.
She quickly proceeded to reassure that the Fed “will strive to clearly and transparently communicate its monetary policy strategy in order to minimize the likelihood of surprises that could disrupt financial markets, both at home and around the world. More importantly, the normalization of monetary policy will be an important sign that economic conditions more generally are finally emerging from the shadow of the Great Recession.”
After low volatility throughout the summer, stock and bond markets showed massive movements in the weeks leading up to the Fed’s October monetary policy meeting, at which it ended its two-year bond-buying program. Although stocks have since risen to record highs, central bank officials have been careful to avoid signaling a monetary tightening that could unsettle investors.
Yellen noted that the U.S. economy has been excessively reliant on the Fed’s easy money policies since the early days of the recession, as fiscal policy has been tight thanks to cuts in government spending and increases in taxes. Starting in 2008, the Fed cut interest rates all the way to zero and massively increased its balance sheet through bond purchases in an effort to stimulate spending and economic growth.
Yellen recommended that the U.S. and other governments reduce their debt and improve their budgets to better prepare for the next downturn.
She said that “governments need to address long-term challenges and significantly improve their structural fiscal balances during good times so they have more fiscal space to provide stimulus when times turn bad,” noting evidence that fiscal stimulus appears to improve the economy when short-term interest rates are at zero and can go no lower.
The experience of the U.S. since the financial crisis also shows the importance of ensuring that the financial system is adequately capitalized and regulated, Yellen said, to prevent such a damaging collapse in the first place.
