janet l yellen : monetary policy and financial stability text of the 2014 michel camdessus central banking lecture by ms janet l yellen, chair of the board of governors of the federal reserve system, international monetary fund, washington dc, 2 july 2014. * * * it is an honor to deliver the inaugural michel camdessus central banking lecture. michel camdessus served with distinction as governor of the banque de france and was one of the longest - serving managing directors of the international monetary fund ( imf ). in these roles, he was well aware of the challenges central banks face in their pursuit of price stability and full employment, and of the interconnections between macroeconomic stability and financial stability. those interconnections were apparent in the latin american debt crisis, the mexican peso crisis, and the east asian financial crisis, to which the imf responded under camdessus ’ s leadership. these episodes took place in emerging market economies, but since then, the global financial crisis and, more recently, the euro crisis have reminded us that no economy is immune from financial instability and the adverse effects on employment, economic activity, and price stability that financial crises cause. the recent crises have appropriately increased the focus on financial stability at central banks around the world. at the federal reserve, we have devoted substantially increased resources to monitoring financial stability and have refocused our regulatory and supervisory efforts to limit the buildup of systemic risk. there have also been calls, from some quarters, for a fundamental reconsideration of the goals and strategy of monetary policy. today i will focus on a key question spurred by this debate : how should monetary and other policymakers balance macroprudential approaches and monetary policy in the pursuit of financial stability? in my remarks, i will argue that monetary policy faces significant limitations as a tool to promote financial stability : its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach ; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. as a result, i believe a macroprudential approach to supervision and regulation needs to play the primary role. such an approach should focus on “ through the cycle ” standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. these efforts

should be complemented by the use of countercyclical macroprudential tools, a few of which i will describe. but experience with such tools remains limited, and we have much to learn to use these measures effectively. i am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability. because of this possibility, and because transparency enhances the effectiveness of monetary policy, it is crucial that policymakers communicate their views clearly on the risks to financial stability and how such risks influence the appropriate monetary policy stance. i will conclude by briefly laying out how financial stability concerns affect my current assessment of the appropriate stance of monetary policy. balancing financial stability with price stability : lessons from the recent past when considering the connections between financial stability, price stability, and full employment, the discussion often focuses on the potential for conflicts among these objectives. such situations are important, since it is only when conflicts arise that bis central bankers ’ speeches policymakers need to weigh the tradeoffs among multiple objectives. but it is important to note that, in many ways, the pursuit of financial stability is complementary to the goals of price stability and full employment. a smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. a strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. and price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability. despite these complementarities, monetary policy has powerful effects on risk taking. indeed, the accommodative policy stance of recent years has supported the recovery, in part, by providing increased incentives for households and businesses to take on the risk of potentially productive investments. but such risk - taking can go too far, thereby contributing to fragility in the financial system. 1 this possibility does not obviate the need for monetary policy to focus primarily on price stability and full employment – the costs to society in terms of deviations from price stability and full employment that would arise would likely be significant. i will highlight these potential costs and the clear need for a macroprudential policy approach