The Federal Reserve Isn’t Done Breaking Stuff

Featured Sponsor

Store	Link	Sample Product
UK Artful Impressions	Premiere Etsy Store

Good day. Ethan here; Rob is out. Thanks to everyone who wrote about tuesday’s letter on US stock valuations. One reader, Paul OBrien, made an important point that I missed: what if stocks are priced fairly for a world with lower returns? It could well be, although it would mean that Shiller’s popular p/e ratio, which is now very high, has failed. BCA Research’s Irene Tunkel notes that Professor Shiller’s measure accurately labeled the 2000 and 2008 bear markets. Any other insights are welcome in the email below.

In other news, Fitch has put the US at “negative clock”, is equivalent to a severe talk-a. Somehow I managed to align my long-planned summer vacation with the deadline. You’ll be in the capable hands of Jennifer Hughes tomorrow and Rob’s next week. But you can still email me: ethan.wu@ft.com.

More things are bound to break

A question looms over this remarkably stable cycle: can the US return to some kind of low-inflation normalcy without breaking the economy in the process? Three recent Federal Reserve investigations offer clues and, I think, some reasons for concern.

The first, published by the New York Fed, focuses on the natural interest rate, or R-star. This is the notional interest rate that balances the economy, without stoking inflation or stifling growth. Monetary policy is only “tight” if the policy rate is well above the natural rate. If R-star were 4.5 percent, as it was in the 1960s, today’s 5 percent fed funds rate hardly seems tight. However, it is annoying that it cannot be observed. The late economist John Henry Williams, as quoted last week by New York Fed President John Williams wrote in 1931 that R-star is “an abstraction; like faith, it is seen by its works.”

The New York Fed has just restarted publishing R-star estimates, which were put on hold after the pandemic hashed their models. Not much has changed; the economy’s equilibrium interest rate has remained low:

Taken at face value, policy rates are some 380 bp above the estimated natural rate. Many economists, including jay powell, have noted how imprecise the R-star measurement is, so skepticism is due. But as Williams said last week, the bottom line is: “There is no evidence that the era of very low natural interest rates is over.” The policy right now is very strict.

The second part of the research also comes from the New York Federal Reserve and concerns a newer idea called the financial stability interest rate, or R-double star. This is the theoretical rate that leads the financial system to the crisis. In its excellent writing On FT Alphaville, Robin Wigglesworth explains:

The idea is that there is also a neutral level of interest rates for financial stability and, fundamentally, it is not the same as R*. Basically, R** is a measure of the financial strength of an economy. When it is low, a country is vulnerable to financial shocks from rate increases, and when it is high, it can more easily ignore them without major setbacks.

Crucially, if R** drifts below R* (for example, if prolonged low interest rates encourage leverage, risk-taking, and general stupidity), central bank rate hikes can cause calamity. long before they get to the point where rates actually start. to contain inflation.

That the Fed’s rate hikes precipitated a banking crisis before inflation dropped even vaguely close to its target seems a case in point. . .

in a pair of blog posts This week, New York Fed researchers expose how lower rates for longer can make the economy fragile. It’s a familiar story, but it’s worth rehearsing. In the short term, low interest rates are good for financial stability. Asset prices go up, leverage (i.e. assets over stocks) goes down, and everyone is happy. But over time, as financial institutions, with their now healthier balance sheets, look for new investments, low interest rates push them into ever riskier things, a classic reach-for-yield dynamic. They stretch too far, leaving the real economy “more to the mercy of fate”. It only takes one wrong move to spark a crisis, including a rate shock aimed at curbing inflation.

The latest piece of research, released yesterday by the Kansas Fed, makes a simple comment: financial crises are not very deflationary. As financial stress hurts both demand (through tighter credit conditions) and supply (through reduced capital investment), the impact on growth is large, but the drag on inflation is small or non-existent . The chart below from the Kansas Fed shows the average effect on inflation, unemployment, and investment in the months after past systemic financial crises. Surprisingly, inflation (blue line) tends to rise as unemployment (green) rises:

Balancing we have:

1. The natural interest rate still looks low, suggesting that the last year of rate hikes has had a large negative impact.

2. An economy that has gone through a decade of low rates is probably one stroke away from a financial crisis.

3. Financial crises are bad anti-inflationary measures.

You can imagine how this ends badly. Inflation remains stubborn, but the financial system is so fragile that rates must be cut. Then inflation turns into expectations and the Fed has to raise rates once more. A deep recession ensues. Powell is awarded the Arthur Burns Memorial Dunce Cap for Easing Too Early.

There are still reasons to be optimistic. The economy has so far weathered the mini-banking crisis. The Fed’s lending facilities are doing his job. Shelter inflation, the hottest part, is coming down. The leverage in the system is low. But remember that cycles often don’t end well. More things are likely to break, and the economy’s remarkable stability probably can’t last.

a good read

the lame ride. A welcome break from all the recent AI techno-doom.