Janet Yellen warns on high stock market valuations

Federal Reserve Chair Janet Yellen on Wednesday described stock market valuations as high and said the central bank was carefully monitoring their impact on financial stability.

"I would highlight that equity market valuations at this point generally are quite high," Yellen said in conversation with Christine Lagarde, managing director of the International Monetary Fund, at an economics conference.

• Fed could calm anxious markets by raising rates

Coupled with weak economic reports in the morning, her remarks drove stocks broadly lower in Wednesday trading.

Yellen added, however, that the overall risks to financial stability are "moderated, not elevated" and she does not see the hallmarks of any bubbles.

Where else can money go?

She cited one reason stock prices were high: the meagre returns on safer investments such as bonds because of low interest rates.

"But there are potential dangers there," Yellen said.

The very low level for short-term and long-term interest rates represented a risk because rates can move rapidly, she explained.

"We saw this in the case of the taper tantrum in 2013 where there was a very sharp upward movement in rates," Yellen said.

The "taper tantrum" occurred when global financial markets were rocked by comments then-Fed Chairman Ben Bernanke made in June 2013. He discussed the possibility that later in the year, the Fed would begin to trim the purchases it was making of long-term bonds, a program designed to keep interest rates low to spur economic growth.

Yellen said the Fed was mindful of the impacts of its decisions. At the moment, investors are intently watching the Fed for signals of when it will start to raise a key interest rate, which it has kept at a record low near zero since December 2008.

Risks from low rates

In her most extensive comments on financial stability, Yellen also discussed the potential stability risks facing banks, insurance companies and pension funds at a time of very low interest rates.

She described the risk as "moderated" because the Fed is not seeing a broad rise in corporate or household debt or any rapid jump in debt levels.

"I would call those things kind of the hallmark of a financial bubble or the precursors of a financial crisis," Yellen said. "But these are things we are of course focusing on very carefully."

The Fed met last week and as expected left its key interest rate unchanged at zero while downgrading its view of the performance of the economy. The Fed offered no sign that a rate increase was imminent. Many analysts have moved their own forecasts for the first rate hike from June to September or even later.

At the conference hosted by the Institute for New Economic Thinking, Yellen and Lagarde posed questions to each other following their prepared remarks.

Stronger financial system

Yellen told Lagarde that she thought the financial system was better equipped now to guard against a repeat of the 2008 financial crisis.

"I think there was a great deal we missed before (the 2008) crisis," Yellen said. "I think we are better positioned now and have better tools."

In her speech, Yellen said that the Fed and other banking regulators had made significant progress in correcting the flaws in the financial system that triggered the crisis.

"Unfortunately, in the years preceding the financial crisis, all too many firms took on risks they could neither measure nor manage," she said.

Banking regulators are remaining "watchful" for any areas where further reforms may be needed, she said. Yellen cited the need to address the problem of "too big to fail" the perception among investors that some institutions are so large that the government will step in and save them if they get into trouble.

The Fed and other regulators are taking steps to ensure that the collapse of even very large banking institutions can be handled in ways that don't jeopardize the stability of the entire system.