Edward Price is director of Ergo Consulting. He is a former British trade officer and also teaches at New York University’s Center for Global Affairs.
As the Great Lodging gives way to the Great Uh-Oh, here’s the problem central bankers face: where the key rate go?
Right now the answer is simple. Upwards. Jay Powell warns of “pain” and “unfortunate costs” for households and businesses. Andrew Bailey says the Bank of England “will not hesitate to raise interest rates”. Christine Lagarde said the ECB “will do what we need to do, which is to keep raising interest rates”.
However, higher rates will eventually lead to recession, illiquidity and insolvency. That can be a challenge for financial stability. If that is the case – if a crisis breaks out – only a lower policy rate will suffice. Unfortunately, lower rates exacerbate upward price pressures. After the “passing inflation” snafu, switching back to housing would cost central banks their remaining street credit. Under these circumstances would be their only option. . . a higher policy rate.
Whatever central banks do, is financial instability the ultimate threat?
Well, but don’t ask me. Ask those responsible. Four economists at the New York Fed recently released a revised 2020 paper titled: The Financial (In)Stability Real Interest Rate, R**.
And what, tell me, is… r-star–star? Again, easy. If r-star is the natural real interest rate associated with macroeconomic stability (caveat emptor), then r-star-star is the rate associated with financial stability. Cool. You can watch the paper’s presentation at a recent Fed event here. It’s exciting.
Spoiler alert though. There is a big catch.
Both conceptually and observationally, r** differs from the “natural real interest rate” and from the observed real interest rate reflecting a tension in terms of macroeconomic stabilization versus financial stability targets.
Excellent. Financial stability ≠ macroeconomic stability. R-star ≠ r-star-star. Moreover, the two ways of separating are exactly when it matters most – a financial crisis (actually when the banking system hits the wall). See these charts:
This is a crisis model we’re talking about, so meanwhile, GDP and investment are falling while credit spreads are rising. That’s every crunch.
But here’s the thing: prices. You cannot reconcile these charts with a lower policy rate. US inflation stood at 8.2 percent in September. Oof.
We can already see this tension playing out. To stifle inflation, US business leaders expect the Fed to give the workforce a beating. Bank of America expects an unemployment rate of 5.5 percent. Frankly, as Larry Summers has suggested, more than 6 percent wouldn’t be weird.
The consensus has now shifted to the view that a recession is likely to occur next year. The average recession is accompanied by an increase in unemployment of 3 percentage points. The most benign involved an additional unemployment rate of 1.5%. The Fed’s forecast of a 4.5 peak looks unlikely. 6 seems like a better bet https://t.co/mt5rOQfjn7
— Lawrence H. Summers (@LHSummers) October 17, 2022
The price mechanism and households thus (sometimes) need different interest rates. Full employment and price stability are (sometimes) at odds. Financial instability, meanwhile, will happily challenge both.
In principle, there are conditions under which the dual mandate (alias: internal equilibrium) has to take a back seat in the capital markets (alias: global equilibrium). According to the paper:
. . . “Greenspan’s pit”. . . has been a feature of all episodes of financial stress in the US [since the 1970s], the only exception being the later part of the Great Financial Crisis. . .[in]In general, we note that periods of financial stress are associated with periods when the real interest rate is above our measure of r**.
Translation: Financial markets want to cut back on their policies. Otherwise, they are going to pay you a visit.
And if they do, you can forget about what fed funds rate you think is appropriate for full employment and/or price stability.
Bravo to the NY Fed. This document has frankly explained exactly what financial instability does.