MNI INTERVIEW:Fed Could Cut Rates Before Summer-Ex-NY Fed Econ

The Federal Reserve could have to reverse course and start cutting interest rates and halting asset runoffs sometime in the next few months if the recent banking crisis devolves into a widespread credit crunch, former New York Fed staffer Gianluca Benigno told MNI.

“They might need to cut rates,” he said in an interview. “I’m not sure that we need to wait until the summer, it might be earlier."

Benigno said the Fed’s quantitative tightening plans, coupled with what he sees as a misguided reverse repo facility, is exacerbating the banking sector’s troubles.

“It works by draining reserves from the banking sector, and there is in my opinion an issue with the overnight RP facility because it’s actually creating the incentive to make things worse,” said Benigno, also a former BOE staffer and ex-consultant to the IMF.

The Fed’s pivot at this week's meeting to maintain optionality including a potential pause might not be enough to offset the looming credit contraction that could result from a prospective prolonged banking stress, he said. (See: MNI INTERVIEW: Powell Nods To Fed Pause But Keeps Options Open)

“There is a pivot so far that says ‘we stay here’ (with rates on hold) but by doing that you keep inflicting pain on the financial system,” Benigno said.

APPROACHING R**

Benigno’s latest line of research focuses on the notion of R** – the natural rate of interest when taking financial stability limitations into account.

“There is a level of interest rate above which financial stress starts. Rates have been rising quite rapidly in the last year or so and we are still in the process of estimating the current R**, but we are getting close to a point at which we are hitting that constraint,” he said.

“One way to think about our model is basically you are draining too much liquidity from financial intermediaries. So there are two forces that are going in the same direction and they can amplify, and actually make R** lower and closer to the current rate.”

TANGLED WEB

The Fed’s efforts to stem the banking sector’s troubles, which first emerged with the collapse of Silicon Valley Bank and Signature Bank but have since spread to First Republic and other regional lenders, harkened back to a consistent playbook of using emergency facilities to deal with financial stability problems, he said.

However, it might not be so simple to maintain this demarcation, the economist, now at the University of Lausanne, said.

“It is difficult to disentangle monetary policy choices from financial stability,” Benigno said. “You have to acknowledge that what you do on the monetary policy side, both in terms of quantitative tightening and in terms of interest rates has implications for eventually what kind of facilities you need to build up.”

“The latest events are indeed an example because with the inversion of the yield curve and the rapid tightening you created a vulnerability in Treasuries and intermediaries of those Treasuries faced unrealized losses.”

That’s why the Fed had to create a special lending facility that allows banks to exchange their loss making Treasuries at par. But what happens when the losses come from a different sector, such as commercial mortgages and other types of loans, is unclear, said Benigno, .

“What’s next, a facility to make sure banks don’t sell discounted commercial loans?”