Fed Chair Janet Yellen Janet Louise YellenFed formally adopts new approach to balance inflation, unemployment Federal Reserve chief to outline plans for inflation, economy The Hill's Morning Report - Presented by Facebook - First lady casts Trump as fighter for the 'forgotten' MORE testified before the Senate Banking Committee on Tuesday and the House Financial Services Committee on Wednesday.

The quick summary is that the Fed views the economy as fairly healthy and expects to raise interest rates, subject to a great deal of uncertainty about economic policy and market data. Additionally, the Fed chair was, at best, cautious about proposals to overhaul the main element of financial regulation, the Dodd-Frank Act.

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First, on the direction of monetary policy, both Yellen’s prepared statement and her testimony to the two committees reinforced the picture painted by the Fed of an economy that is now nearing its capacity limit.

Despite what Mrs. Yellen characterized as “disappointingly” slow growth since the end of the recession in 2009, she pointed to recent increases in inflation and the growth rate of wages as signs that the economy cannot be pushed a great deal further.

This view implies that the Fed will need to raise interest rates to make monetary policy less stimulative. Mrs. Yellen, continuing long-standing practice, did not commit to specific timing or amounts of interest rate increases.

But Charles Evans, president of the Chicago Fed and one of the Federal Open Market Committee members most resistant to rate increases, commented that as many as 3 quarter-point increases in the next year would be a reasonable guess. This would still leave the federal funds rate, the main interest rate that the Fed tries to manage, at a range of 1.25-1.5 percent, quite a low level historically.

The Fed’s reluctance to commit to interest rate changes in advance stems from the difficulty in forecasting future developments and the need to respond to incoming information. House Republicans criticized this “discretionary” approach, renewing a long-standing argument against activist economic management.

However, the Fed itself, along with a substantial portion of the academic community, has long argued that a predictable, rules-based approach would simply be too rigid, depriving the central bank of the ability to respond quickly to major shifts in economic conditions.

The Fed’s reluctance also stems from the enormous uncertainty about economic policy. The new administration has only given general indications about its intentions to loosen regulation and lower taxes. Until more concrete proposals are elaborated, the Fed has limited ability to assess the possible impacts.

The Fed probably has no more insight than anyone else into whether the budget will include lower taxes and spending cuts, with a moderate effect on the Federal deficit, or lower taxes and fairly stable spending, leading to substantial increases in the deficit.

Furthermore, changes in trade policy are the proverbial elephant in the room. They could have massive macroeconomic effects, and they are, at this point, completely unclear.

Chair Yellen also pointed out a second implication of the Fed’s assessment that the economy is near full capacity, rendering further monetary stimulus ineffective. In her written testimony, she called for policies that would increase productivity.

Such measures could stimulate long-term growth of the economy. Simply increased deficit spending, like monetary stimulus, would be more likely to generate inflation than faster growth. When asked what sorts of measures she would recommend, Mrs. Yellen, quite mindful of the importance of defending the Fed’s independence, declined to enter the legislative fray.

Still, Mrs. Yellen could not avoid politically controversial questions. The president’s executive order on financial reform has called for a review of the Dodd-Frank Act with an eye to decreasing the regulatory burden.

Congressional Republicans have characterized the act’s heavy demands of banks, including enhanced capital and liquidity requirements, as a major limitation on lending, which in turn, they claim, has harmed economic growth.

Mrs. Yellen pointed out, however, that lending growth is now quite substantial in most segments of the credit markets. In the immediate aftermath of the Great Recession, banks had to be cautious about lending, both because they needed to rebuild their balance sheets and because they wanted to avoid new loan losses.

Economists Kenneth Rogoff (former International Monetary Fund chief economist) and Carmen Reinhart have documented the slow recovery of lending after major financial crises in history, showing that slow lending makes for weaker, longer-lasting recoveries from recessions that are coupled with financial crises.

In short, much of the slow recovery of lending after the recession was probably inevitable. In addition, it is important to debunk the notion that the Dodd-Frank Act’s higher capital requirements led to banks holding on to idle money. Capital is a source of funding and a buffer against losses.

Higher capital requirements make it less likely that loan losses or other charges will put a bank into insolvency. This lowers the chances that taxpayer money will be needed to help banks. To see higher capital requirements as a major brake on bank lending is to miss these important benefits. They're more of a self-serving defense of banks’ perceived interests than a substantial economic argument.

The Dodd-Frank Act attempted to fix the glaring deficiencies of the regulatory system that allowed such an enormous crisis to occur.

A lack of coordination among regulators, unregulated systemically-important institutions, a lack of mechanisms to swiftly manage the failures of systemically-important institutions, a complete lack of standards for liquidity, and very weak capital requirements stand out as major defects of the pre-Dodd-Frank regulatory system.

Even Hank Paulson, on his arrival from Goldman Sachs to the Treasury Department, recognized the need for a major overhaul.

Getting the balance between regulation to make the financial system safer and mitigate crises and leaving freedom for lending and innovation is difficult. Yellen agreed with House Republicans that these questions can and should be examined carefully.

She agreed that some of the regulatory burdens the act imposes on smaller, community banks may be excessive, and she did not explicitly defend the Volcker Rule, a Dodd-Frank provision that limits commercial banks’ ability to engage in certain risky but lucrative investment banking activities. But she did not concur with the assessment that financial regulation is the main factor holding our economy back.

The argument that regulation is the main enemy will be one that we will probably hear a lot in the coming months. Yellen’s testimony is just one early piece of the conversation. But it is already clear that a major battle lies ahead, one that can easily jeopardize the long-term stability of our financial system.

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.

The views expressed by contributors are their own and not the views of The Hill.