Tentative signs of improvement in recent economic data do not mean the U.S. economy is out of the woods, Janet Yellen, president of the San Francisco Federal Reserve, said on Thursday.
Yellen, a voting member of the policy-setting Federal Open Market Committee in 2009, said the carnage of the credit market bust has made her reconsider whether the Fed should take preemptive action against developing asset bubbles, which she said can be economic time bombs.
The negative dynamics between the real and financial sides of the economy have created severe downside risks, Yellen told a conference organized by the Levy Economics Institute of Bard College in New York.
While we've seen some tentative signs of improvement in the economic data very recently, it's still impossible to know how deep the contraction will ultimately be.
Yellen said that as the United States enters its sixth quarter of recession, economic activity and employment are still contracting sharply as the adverse feedback loop between financial markets and the overall economy rolls on.
Fed credit policies have created a few welcome signs of stability but financial markets remain highly stressed, an impediment to recovery, Yellen warned.
POPPING ASSET BUBBLES
Yellen spoke at length on the unbridled risk-taking that led to the financial and economic meltdown, reexamining whether central banks such as the Fed should act to prevent asset bubbles as they develop.
It's evident that episodes of exuberance, like the ones that led to our bond and house price bubbles, can be time bombs that cause catastrophic damage to the economy when they explode, Yellen said.
Many factors combined to create the U.S. housing price bubble earlier this decade, with the Fed's accommodative policy of 2002 to 2004 -- a calculated risk against deflation -- among them, Yellen said.
Although the financial crisis that erupted in 2007 is often associated with the U.S. subprime mortgage market, Yellen said risky practices were at work broadly in the U.S. and global financial system and many U.S. households enthusiastically joined a cult of risky behavior.
When optimism is high and ample funds are available for investment, investors tend to migrate from the safe hedge end of the ... spectrum to the risky, speculative and Ponzi end, she said.
The Fed's standard line has usually been that monetary policy is too blunt of a tool to use to target asset bubbles.
Now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look, Yellen said.
Credit booms hold more dangerous systemic risks than other asset bubbles, such as the technology stock boom of the late 1990s that was mopped up with comparatively little damage, she said.
I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy.
Like many of her Fed colleagues, Yellen said action needed to be take to clean up the financial regulatory and financial system.
The current system of supervision is characterized by uneven and fragmented supervision, and it's riddled with gaps that enhance the opportunity for regulatory arbitrage, she said.
Systemically important institutions, including certain banks, insurance firms, investment firms, and hedge funds, should be subject to consolidated supervision by a single agency, Yellen added.
(Writing by Ros Krasny in Chicago; Editing by Leslie Adler)