MNI INTERVIEW: Higher-For-Longer Rates Risk Volatility

Keeping interest rates at high levels for an extended period of time risks further episodes of financial instability and could undermine policymakers’ aims of achieving macro-economic stability, a former head of international research at the New York Fed told MNI.

Gianluca Benigno, who with Fed colleagues has developed the concept of R double star, the level of rates at which financial stresses trigger self-reinforcing fire sales, said the dilemma for policymakers comes when this point has fallen below the more established R star measure, the rate compatible with macro-economic stability. That would mean that even hiking even to neutral means moving into the financial instability zone, he said, noting how the U.S. has already seen bank failures and the UK gilt market turmoil against a backdrop of tighter monetary policy.

"The R double star concept can be interpreted as a sort of ceiling or maximum level that you can have in terms of interest rates," which makes it policy sensitive, Benigno said, without giving an estimate of where it lies. He and his colleagues have attempted to locate it using credit spreads but he hopes that further research will develop better measures by, for example, combining leverage and safe assets.

"One implication of our framework, is that you if you keep interest rates high-for-long that tends to create more vulnerabilities from a financial sector point of view, and this vulnerability.. slowly translates into a decrease in R double star," he said.

MACROECONOMIC, FINANCIAL STABILITY

While policymakers, who in several countries are leaning towards leaving rates at peak for an extended period, like to make a clean separation between monetary policy and financial stability setting, Benigno said things are not that simple.

"You cannot achieve macroeconomic stability if there is financial instability,” he said, adding that "As much as you want to have this separation principle in mind .. you need to acknowledge that interest rate movements and (associated) financial stability implications are very important."

The concept has already permeated the thinking of policymakers with current Bank of England Monetary Policy Committee member Catherine Mann telling a recent Pictet event a big gap between R star and R double star could lead to a situation with "an awful lot of volatility" and "things breaking.”

While the UK’s liquidity-driven investment turmoil and the U.S. bank failures both had idiosyncratic features Benigno highlights the common factors of vulnerability to higher interest rates. (See MNI INTERVIEW: Fed’s QT Could Trigger Liquidity Crunch-Rajan)

But some policy steps designed to bolster stability can push R double star upwards, making it less likely that rate increases will trigger instability, One example was the Fed’s move in March to create the Bank Term Funding Program to allow banks to borrow using Treasury bonds as collateral, valuing them at par.

The BTFP made "Treasuries almost equivalent to a safe asset (and) .. one way to think about that policy action is that it would be translated into an increase of R double star," Benigno said.

On the other side of the coin quantitative tightening, currently being conducted by the Fed and BOE among others, would if it feeds through into a reduction in central bank reserves push down R double star by reducing the availability of safe assets, he said. (See MNI INTERVIEW: US Treasury Cash Rebuild To Force Early QT End)