Federal Reserve Board Chair Janet Yellen.

The United Kingdom exiting the European Union could be “significant” for the U.K. and Europe, ushering in a period of economic “uncertainty and volatility that would negatively affect financial conditions” there as well as the U.S. economic outlook, Federal Reserve Board Chair Janet Yellen told senators Tuesday.

Addressing questions from members of the Senate Banking Committee about a Thursday vote on a so-called Brexit, Yellen told members of the committee that the financial market reaction could possibly include a “kind of risk-off sentiment impact … on financial markets, with a flight to safety flows that push up the dollar and other safe-haven currencies.” The Fed, Yellen continued, “will consider those impacts as we make future decisions on monetary policy.”

When pressed on whether a Brexit could throw the U.S. economy into recession, Yellen responded: “I don’t think that’s the most likely case, but we’ll have to watch it carefully.”

During the two-and-a-half hour hearing, Yellen also addressed the Oct. 1 deadline for the five large banks to revise their “living wills,” which outline how the banks would unwind themselves in bankruptcy without a taxpayer bailout. The Fed and the Federal Deposit Insurance Corp. in mid-April ordered several big banks — including Bank of America, State Street, Bank of New York Mellon, Wells Fargo and J.P. Morgan — to revise their living wills by the deadline or potentially face sanctions.

“We are insisting that the firms address shortcomings that we’ve found in the living wills in the last submission,” Yellen said. “If the firms fail to address deficiencies, or if by summer of 2017 they fail to address shortcomings, Dodd-Frank says the Fed and FDIC can impose higher capital requirements. I don’t expect to have to go there, but we are asking them to address the shortcomings we’ve identified.”

Sen. Elizabeth Warren, D-Mass., pressed Yellen to commit to enforce Dodd-Frank’s higher capital standards and stricter leverage ratios on the banks if they fail to resolve their living will deficiencies.

Yellen responded that while the Fed has “been very serious in review of living wills, … those are decisions that my colleagues and I will need to look at. We are very serious about wanting to see these deficiencies remedied. I can’t pre-commit to say what precisely our response will be. We will work closely with the FDIC.”

As to the economy, Yellen told lawmakers that since appearing before the committee in February, “the economy has made further progress toward the Federal Reserve’s objective of maximum employment.”

While inflation has continued to run below the Fed’s 2% objective, the Federal Open Market Committee “expects inflation to rise to that level over the medium term. However, the pace of improvement in the labor market appears to have slowed more recently, suggesting that our cautious approach to adjusting monetary policy remains appropriate,” she said.

The Fed voted on June 15 to leave interest rates unchanged, maintaining the federal funds rate — the rate that banks charge each other for overnight loans — at 0.25% to 0.50%. 

Yellen noted during her Tuesday testimony that the FOMC has also kept the Federal Reserve’s holdings of longer-term securities at an elevated level. “The Committee’s actions reflect a careful assessment of the appropriate setting for monetary policy, taking into account continuing below-target inflation and the mixed readings on the labor market and economic growth seen this year,” she said. “Proceeding cautiously in raising the federal funds rate will allow us to keep the monetary support to economic growth in place while we assess whether growth is returning to a moderate pace, whether the labor market will strengthen further, and whether inflation will continue to make progress toward our 2% objective.”

If inflation were to remain “persistently low or the labor market were to weaken,” Yellen noted, the FOMC “would have only limited room to reduce the target range for the federal funds rate. However, if the economy were to overheat and inflation seemed likely to move significantly or persistently above 2%, the FOMC could readily increase the target range for the federal funds rate.”

She added that the FOMC “continues to anticipate that economic conditions will improve further and that the economy will evolve in a manner that will warrant only gradual increases in the federal funds rate.”

As to negative interest rates, Yellen noted that while the Fed does “have the legal basis to pursue negative rates, … it’s not something we’re considering. We have identified shortcomings in that type of approach.”

Sen. Richard Shelby, R-Ala., chairman of the committee, asked Yellen if the Fed continues to use “forward guidance to shape market expectations,” noting that the Fed being “incorrect” on interest rates has caused it to “lose credibility.”

Yellen responded: “In the past several months we have used forward guidance less than we did in the aftermath of the financial crisis … We’re not relying very much on forward guidance. We do publish every three months participants’ projections on the federal funds rate that they believe will be appropriate on performance of the economy. Those projections are helpful to the public in understanding the path of the economy.”

On another note, Yellen also said that the Fed’s authority is “extremely limited” regarding helping Puerto Rico’s current economic crisis, adding that “it wouldn’t be appropriate to give loans to Puerto Rico. We have no ability to make emergency loans.”

— Check out Gundlach Blasts Policies of ‘Zombie Fed,’ Negative Rates on ThinkAdvisor.