SHELBY: Madam Chair, the FOMC's target for the fed funds rate has been at one-half percent or lower since December, 2008. A report last year from the Bank of International Settlements found that the prolonged period of low interest rates may be damaging the U.S. economy resulting in, and I'll quote, "Too much debt and too little growth." In addition the report states, "The low rates may in part have contributed to costly financial booms and busts."

Do you agree that persistently low interest rates can have negative long-term effects on the U.S. economy and could you explain?

YELLEN: Well, I believe that persistent low interest rates we've had have been essential to achieving the progress, but of course low rates can induce households or banks or firms to reach for yield and can stoke financial instability and we are very attentive to that possibility and I would not at this time say that the threats from low rates to moderate to financial stability are elevated. I do not think they're elevated at this time, but it is of course something that we need to watch because it can have that impact. You mention debt, I don't think we're seeing an (inaudible) build up of debt throughout the economy.

Taken together, the economic data generally point to an economy that is moving in the right direction and has consistently sustained growth over the past five years. This is not to say the economy is issue-free… Unfortunately, although we might wish it so, monetary policy is not the proper tool to address all of these issues. The aggressive monetary actions over the past few years were intended to support economic activity, help labor markets heal and move inflation toward the Fed’s target. I view the considerable progress in labor markets and the relatively steady inflation rate as encouraging. However, keeping interest rates near zero to achieve still further progress toward labor market improvement and higher inflation is risky in my view. In a protracted period of exceptionally low rates, investors seeking out higher returns are willing to take on more risk or seek out more creative financing approaches. When the economy is expanding and rates remain low, adverse events may appear less likely or far into the future, potentially resulting in the mispricing of risk and financial assets. Waiting too long to adjust rates, as we’ve seen in the past, can leave policymakers with few and possibly poor options. … The FOMC has been talking about its exit strategy since 2011. And since March of this year, the Committee has been emphasizing that a decision to raise interest rates would be data dependent. In other words, economic data that confirms further gains in the economy’s performance will drive the timing of the Committee’s actions. So, why hasn’t the FOMC yet raised rates? There are of course different views on the economic data we receive and analyze that lead to legitimate, differing views about what is best for the economy… The continued improvement in the labor market, combined with low and stable inflation, convince me that modestly higher short-term interest rates are appropriate. Current guideposts, or “policy rules,” often used to inform monetary policy decisions also have been signaling that interest rates should be higher. I recognize that a rate increase, however, would be the first one in nearly a decade. So I am not suggesting rates should be normalized quickly or that policy should be tight. Although the economy has improved, economic fundamentals could well mean an accommodative stance of policy is appropriate for some time. I would like to avoid the cost of waiting for more evidence and further postponing liftoff, drawing on a valuable lesson from monetary policy decisions in 2003.

Recent research by Board staff, using a database of loans primarily to U.S. borrowers but also to some foreign borrowers, suggests that lenders have indeed originated an increased number of risky syndicated loans post-crisis, based on the assessed probability of default as reported to bank supervisors. Regression results confirm that the average probability of default is significantly inversely related to U.S. long-term interest rates. This increase in riskiness of syndicated loans post-crisis has been accompanied by a shift in the composition of loan holders: An increasing share is now held not by banks but by hedge, pension, and other investment funds (figure 2). These nonbank investors also tend to hold loans with higher average credit risk (figure 3). These data suggest that a tougher regulatory environment may have made U.S.-based bank originators unable or unwilling to hold risky loans on their balance sheets.

Taken together, developments in U.S. bond portfolios do not indicate a worrisome pickup in risk-taking in external investments. But it is important to recognize that portfolio reallocations that seem relatively small for U.S. investors can loom large from the perspective of the foreign recipients of these flows. At roughly $400 billion at the end of 2012, emerging market bonds accounted for a tiny fraction of the roughly $25 trillion in bonds held by U.S. investors. But to the recipient countries, these holdings can account for a large fraction of their bond markets. Even relatively small changes in these U.S. holdings can generate large asset price responses, as was certainly the case in the summer of 2013. Likewise, a reassessment of risk-return tradeoffs could disrupt financing for projects that are dependent on the willingness of investors to participate in global syndicated loan markets.

We take the consequences of such spillovers seriously, and the Federal Reserve is intent on communicating its policy intentions as clearly as possible in order to reduce the likelihood of future disruptions to markets. We will continue to monitor investor behavior closely, both domestically and internationally.

Figure 16 highlights how low 10-year Treasury rates have fallen recently. Japans experience and now Europes current situation both indicate that indifference to very low inflation rates can generate a significant loss of confidence in the ability of a central bank to hit its inflation goal. It is hard to reconcile the market evidence a 10-year German bond trading around 85 basis points and a 10-year Japanese bond trading below 50 basis points with the publicly announced inflation targets. Bond market evidence suggests that investors have little expectation that 10-year average inflation rates will be anywhere close to their publicly announced targets.

Together with the healthy rejuvenation of the balance sheets and equity prices of investment grade companies, we have seen what I consider to be a manifestation of an indiscriminate reach for yield, a revival of covenant-free lending, and an explosion of collateralized loan obligations (CLOs), pathologies that have proved harbingers of eventual financial turbulence.

Noticeably affected by QE3 have been the nominal yield levels of subpar credits and their spreads relative to investment-grade issues. Some 40 percent of newly issued CCC credits have negative cash flows.[2] And yet junk bonds have been trading at or near record historic low yields both in absolute terms and as measured by spreads over investment-grade credits. I worry about this as a risk that has been propagated by QE3, though I do not believe it is the Feds job to rescue reckless investors from the errors of their ways.

The stock market bottomed in March 2009 and had already more than doubled by the time we initiated QE3. It has since risen by another 40 percent; equities have, all-in, tripled in price since the lows of 2009. Only time will tell if stocks have risen to unsustainable heights and, if so, how deep a correction might be needed to bring them back to sustainable valuations.

As a result of near-zero interest rates for five years, the profitability of traditional banking activities is strained and incentives to reach for yield are tempting. Net interest margins continue to trend lower and are at their lowest level in 30 years. Banks are responding as we should expect, which is to say they are engaging in riskier activities. For example, an all-time high of $600 billion of leveraged loans were issued in 2013. This lending is often characterized by weaker underwriting standards, including higher debt ratios and fewer covenant provisions.

The incentives to reach for yield extend to smaller financial institutions as well. Commercial banks with assets of less than $50 billion have increased exposure to interest rate risk, due in part to the guidance the FOMC has provided regarding future interest rates. Today, 53 percent of the securities and loans held by these banks have maturities of more than three years, compared to about 37 percent back in 2005. If longer-term interest rates were to suddenly move higher, these institutions could face heavy losses.

I would like to see short-term interest rates move higher in response to improving economic conditions shortly after completion of the taper. Many of the rules offering policy guidance on the federal funds rate such as the Taylor rule and its variants are already or close to prescribing a policy rate higher than the current funds rate. Second, the path toward the longer-term neutral funds should be gradual. Given the lengthy period of unconventional policy and low rates, the necessary adjustment by financial markets to less central bank intervention and influence could be volatile. In this environment, the pressure to quickly back away from a rising rate policy will be significant; such pressures will need to be resisted. If not, we risk moving into a confusing stop-and-go policy environment.

In terms of the path after liftoff, the FOMC has signaled that it will take a gradual approach toward the longer-run funds rate... So, the funds rate could reach its longer-run level well after the economic recovery is complete and inflation has returned to the 2 percent goal. These signals suggest to banks that they will continue to contend with a low interest rate environment for a few years, even as economic conditions are likely to improve. I see this as a set of conditions ripe for greater risk-taking as firms reach for yield and the imbalances related to such incentives grow.

Gradualism can promote financial stability, as it reduces the incidence of unexpected shifts in interest rates. Even so, the degree of inertia suggested in the median path of the federal funds rate in the FOMCs Summary of Economic Projections goes beyond what is required to achieve a smooth exit. In my view, it will likely be appropriate to raise the federal funds rate at a somewhat faster pace than the median of committee members projections. Low rates into late 2016 will likely continue to provide incentives for financial markets and investors to reach for yield in an economy operating at full capacity and risks achieving our objectives over the longer run.