The topic du jour across markets and macro in October is the “breakage” discussion. Posed as a question, it’s: “How long before Fed hikes break something?”
The answer, I’ve suggested, is that they’ve already broken something. Several things, in fact. The yen, to name one. And gilts to name another. There will be more casualties before this tightening cycle is complete. The US economy may be among the wounded, if not the deceased.
Everyone is talking about this, and I don’t just mean sell-side analysts and hedge fund managers preening for the CNBC cameras. It was the subject of Larry Summers’s latest chat with Bloomberg Television. Stephanie Kelton penned something short about it a few days ago called, “(When) Will the Rate Hikes Break Something?” And Wall Street Journal “Fed whisperer” Nick Timiraos alluded to it in a Saturday article. “Some economists fear the Federal Reserve — humbled after waiting too long to withdraw its support of a booming economy last year — is risking another blunder by potentially raising interest rates too much to combat high inflation,” he wrote.
It’s safe to say the “breakage” discussion has gone mainstream.
What’s not well understood (so, what’s not mainstream), is why this time is so perilous. I reiterated the main points here on Saturday while discussing Summers’s remarks to Bloomberg. In short, the torrid pace of rate hikes comes on the heels of a dozen years spent in a regime defined by the pervasive deployment of leverage, and the herding of investors out the risk curve and down the quality ladder, in an increasingly desperate, globalized hunt for yield. The viability (and stability) of that regime depended entirely on central banks operating in vol-suppression mode, mostly via forward guidance. Modern market structure was built around and atop the attendant low-vol regime. Loosing the ghost of Paul Volcker into that environment is extraordinarily dangerous.
The implication is that the amount of Fed tightening markets can absorb without “some kind of financially traumatic event” (as Summers put it) is probably much lower than what the real economy can take without rolling over.
Well, as it turns out, researchers from the New York Fed addressed this in a recent paper which, going strictly by the introduction, sounded very promising. To wit, from “The Financial (In)Stability Real Interest Rate, R**,” by Ozge Akinci, Gianluca Benigno, Marco Del Negro and Albert Queralto:
One of the key aspects that has characterized the global economy and in particular advanced economies in the last two decades is the secular decline in real interest rates. The decline in global real interest rates has largely occurred in a context of relatively low and stable inflation suggesting that the drop in observed real interest rates reflects a fall in what researchers refer to as the “natural real interest rate,” also known as r*. The concept of natural real interest rate dates to Wicksell (1898) and it is usually defined as the real rate consistent with real GDP equals to its potential in the absence of shocks to demand. In turn, potential GDP is defined to be the level of output consistent with stable price inflation absent transitory supply shocks. In short, the concept of natural real interest rate is associated with the notion of macroeconomic stability. We propose a complementary concept that we call the “financial stability real interest rate, r**.” The core idea relies on determining the underlying level of real interest rate that might generate financial instability dynamics. 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 objectives.
Just like the natural rate of interest provides a benchmark for monetary policy in terms of macroeconomic stability, r** is meant to provide a benchmark for financial stability: If the real rate in the economy is at or above r**, the tightness of financial conditions may generate financial instability. Like the natural interest rate, the financial (in)stability real interest rate is state dependent: It evolves with the conditions of the economy, and in particular with the degree of imbalances in the financial system.
Again, that sounded promising. And it was promising, even as the conclusion, delivered some 30 pages later, was entirely predictable. “We show that as the banking sector becomes more leveraged, the financial stability interest rate becomes lower,” the researchers wrote, adding that “this has implications for monetary policy, in that even relatively low levels of the real interest rate could trigger financial instability.”
In fairness (and for those who haven’t read or written any peer-reviewed journal articles), I should note that the conclusions are almost always obvious in academic papers. If these sorts of works were movies, you’d know “who did it,” so to speak, during the opening credits. Every, single time. So, the fact that four people did a lot of writing (and even more math) to come to a wholly obvious conclusion isn’t unique to this paper. It’s how this sort of research works.
Bloomberg offered the following concise summary: “The authors argue that after a period of sustained low rates, similar to our current situation, the gap between R** and R* widens, with R** falling below R*. This means with excess leverage built up, the neutral rate for the financial system drops below that of the real economy.”
This could scarcely be any more topical. The idea is that thanks to leverage and years of subdued real rates, a financial stability shock may come knocking before the Fed is able to raise rates to levels consistent with price stability. As Bloomberg put it, “in effect, the Fed [could] fail to rein in inflation before it’s forced to pause to tackle financial instability at home… the same situation that the Bank of England blew wide open last week with their emergency QE operation.”
I wasn’t the only person excited about the paper’s potential. Rabobank’s Michael Every was likewise “delighted a central bank might recognize the tensions behind the financialized economy and the real economy,” as he put it, in a note published October 7. Suffice to say Every became less enamored with the paper the more he read.
As much as I don’t want to downplay the authors’ efforts to quantify and deal systematically with what might fairly be described as the most vexing issue underlying the most critical macro discussion currently dominating the daily discourse, I’d be positively remiss not to highlight Every’s critique. It is, bar none, the most entertaining piece of macro-focused writing I’ve read in years, and quite possibly the most entertaining piece he’s ever produced, which is really saying something (everything he writes is entertaining).
What follows is Every’s deep-dive, presented without additional editorializing on my part, other than to offer my sincere congratulations to Mike on a superb piece of analytical satire.
Via Rabobank’s Michael Every
Earlier this week, one of my colleagues shared a recent research paper from the New York Fed — ‘The Financial (In)Stability Real Interest Rate’ — which argues the US natural real interest rate for the real economy is not the same as the natural real interest rate for the financial economy, or the “financial stability real interest rate.”
I was delighted a central bank might recognize the tensions behind the financialized economy and the real economy and, by extension, that one size interest rate does not fit all, least so in geopolitical/geoeconomic crises. Then I read the paper.
Let’s just say that the authors and I do not agree on how the world works. In fact, I am not sure anyone but a quant-heavy economist would recognize any of what is described as reality.
Allow me to dig in, if only to show that this kind of thinking ends up as policy recommendations for the people who set the cost of borrowing. Be afraid. Be very afraid. Or annoyed. Very annoyed. Or amused. Very amused. It’s up to you.
First, the paper develops its concept of r** on the framework developed by Gertler and Karadi (2011) and Gertler and Kiyotaki (2015). Why not Minsky, who wrote the book on this topic decades ago? Why not the Minsky model built by Keen? Instead, they refer to a paper that boldly claims, ”We develop a canonical framework to think about credit market frictions and aggregate economic activity,” which ALSO does not lean on Minsky, while claiming Bernanke as a key source(!) The guy who said “sub-prime is contained,” and that high levels of private debt do not suggest a crisis unless you assume vastly different marginal propensities to consume.
Then things get worse. The authors display they do not understand banks — and this from the New York Fed — when stating “financial intermediaries channel funds from households to firms.” Wrong, as even the BoE admitted years ago.
Then we come to their actual model of how the US economy ‘works,’ which is surreal:
“2.1 Households
Each household is composed of a constant fraction (1-f) of workers and a fraction f of bankers. Workers supply labor to the firms and return their wages to the household. Each banker manages a financial intermediary (“bank”) and similarly transfers any net earnings back to the household. Within the family there is perfect consumption insurance.”
Yes, my household is 1 banker, me, and 1 “worker,” my wife — but this is hardly representative.
“2.2 Banks
Banks are owned by the households and operated by the bankers within them. In addition to its own equity capital, a bank can obtain external funds from domestic households.”
I don’t own any banks myself. Do you?
“2.2.1 Agency friction and incentive constraint
We follow Gertler and Kiyotaki (2010) in assuming that banks are “specialists” who are efficient at evaluating and monitoring nonfinancial firms and at enforcing contractual obligations with these borrowers. For this reason firms rely solely on banks to obtain funds and there are no contracting frictions between banks and firms.”
Again, these guys don’t know that is NOT what Wall Street does, or how it doesn’t do it.
“2.2.2 The banker’s problem
The bank pays dividends only when it exits. If the exit shock realizes, the banker exits at the beginning of t+1, and simply waits for its asset holdings to mature and then pays the net proceeds to the household. The objective of the bank is to maximize expected terminal pay-outs to the household.”
Now we are in science fiction. Banks pay dividends all the time to a narrow slice of households. When they exit, they leave the bill with the central bank, who passes it on to workers either directly, or indirectly via inflation and asset-price inflation. The objective of the bank is to make money and exit without going to jail.
Overall, just as the authors use people who did not see financial instability coming as guides over ones who did, they use ridiculous models of the economy rather than the accurate sectoral balance sheets of Godley.
Then we are on to interest rates:
“2.4 Interest rate determination
We assume that the safe rate, Rt, evolves (mostly) exogenously. The goal is to capture fluctuations in the natural real interest rate, without taking a stance on their causes.”
So the base rate of interest ‘just happens’ outside the model! What are we modeling again? That “stuff happens”?
Their final conclusion is that: “as the banking sector becomes more leveraged, the financial stability interest rate becomes lower. This has implications for monetary policy, in that even relatively low levels of the real interest rate could trigger financial instability.”
Well done! But Marx said the same in the 19th century; Keynes in the 1930s; Minsky over 40 years ago; Kindleberger in 1978; Godley two decades ago.
The point today is that the real economy is not the financial economy. Even as asset inflation reverses, real world inflation is high. Real world supply-side inflation is going to stay high, because production is being shut off to ensure that outcome.
So, we have to have higher interest rates, even if financial markets won’t like it. And rather than an R* to please markets, we may see R**, R***, R****, and R***** — and some of those rates are going to be effectively zero — as governments and central banks jointly decide who is essential and who isn’t in the face of a supply-side economic war.
That is how political-economy worked for a very long time. The post-80s experiment of one central bank rate to allocate capital where markets most want it to go is as much as an aberration to long-run norms as free trade is to the mercantilism that preceded it, and will likely succeed it.
At the risk of sounding too pedestrian, “that is not how this works; that’s not how any of this works!”
Maybe economists should spend more time with the risk people in banks, market makers, pension funds, insurers, bond shops, options traders, hedge funds, asking “what actually happens to your book if rates go to X? to Y? And why, how, when?” Would likely be more productive than inventing stylized models of a household-and-widget economy that only exists in their heads.
More generally, as the economy that economists are supposed to understand becomes increasingly financialized, the critical mechanisms and linkages are less about households and widgets and more about leverage and derivatives, which most economists don’t seem to know much about.
jyl: Hear, hear. I risk some credibility when I say this, but I have never met an economist that understood the real world, how people and businesses actually behave. The thing is an economist can now earn a Nobel Prize, therefore economics is a science, therefore it must have quantitative models it can use in research, therefore … Real life can’t really fit these models because they aggregate the behavior of billions of individuals and businesses, small and large. The models just don’t get the “color” aspect of the game. I get the same feeling when I hear Powell and his cronies talk about us and what will happen to millions of us, as I had when I listened to generals talking about the daily details of the Korean War and the Vietnam War and they told us how many deaths were “acceptable.” Acceptable to whom? None of those guys was on the front lines seeing which actual guys were part of the acceptable loss group. I get my house cleaned by individuals who may well not have a job soon because they fall into that “acceptable pain” group that will arise as Powell attempts to channel Volcker. There won’t even be a memorial for these people. I provide support to my local food bank that distributed 50 mil pounds of food last year in its service area, 25 pounds for every man, woman, and child in the area … you know, part of the collateral damage the economists just can’t worry about. I’ll keep sending them as much as I can afford.
Yes, I fear that too much academic economics is of the “let us define the behavioral sets of X sub i and Y sub j such that the transitive property of their intersections blah blah” variety, which seems profound and rigorous to economists but looks infantile to the mathematicians that they are pretending to be and utterly addled to the business operators, traders, bankers, etc who they need to understand.
Ask a mathematician “What does two plus two equal” and the mathematician will say “Four.”
Then ask an accountant the same question and they will say “On average, four – give or take ten percent, but on average, four.”
Then ask an economist the same question and they will say “What would you like it to equal?”
Anyway, back to the topic of breakage – I remain convinced that the Fed will not stop to avoid breaking something they can’t easily fix, they will stop when they break something they can’t easily fix.
I don’t have an opinion about whether that happens before they slow the economy “enough”. Economic slowdown may be another of those “first gradually, then suddenly” things.
For now, best to assume tightening continues unrelenting, and not get excited by “pivot” talk. That ain’t happening.
Look at Brainard’s comments today – despite all her dovish-tinged caution, she still says she’d keep tightening (to her target level) until problems emerge (and she’ll watch carefully for those problems), which is different from saying she would try to predict the tightening level that will trigger problems (and stop short of that).
In other worlds, another variant of “tighten until something starts to break” (or reach target FF, or inflation caves).
The interesting thing is, I have to think that the Fed is in fact watching spreads and liquidity and CDS and other financial datapoints, in addition to real economy data points, very very carefully. The FOMC has a small army of analysts, who can get access to most data including internal and confidential (I’ve mentioned this before, but when I covered UPS they were sharing their internal shipment data with the Fed).
The British pension funds were telling the BOE weeks before the crisis that they were going to blow up (which gave the BOE time to prepare), and large US institutions should have similar channels to communicate with the Fed. Surely Jamie Dimon can pick up the phone and reach some New York Fed staffer within minutes.
If that is true, tough Fedspeak could indicate that there are in fact not yet major cracks starting to appear in places that we don’t see. (And, of course, that the Fed is just not that moved by crises in other countries, so long as they are manageable by the local CB.)
While I realize this isn’t the type of report that “sells,” it’s absolutely my favorite.
In 2020 we learned that supply chain robustness was actually a desirable thing–and we had allowed the global system to move away from it. Even earlier, we had learned (but didn’t act on) the idea that the banking system, and the financial system as a whole, needed to be robust–and that what we have is not robust. We should not need to make policy decisions based on “unknown unknown” financial derivative landmines that might be out there. Privatized reward based on socialized risk does not make for a good society. Elizabeth Warren gets mocked these days, but she was on the right path when she campaigned for making banking boring again.
+1
joey. Wow, great comment. “streamlining the supply chain made money in the short run, but exposed us all to enormous risks arising from disruptions. We watched Lehman die and never put two and two together there, either.
“The objective of the bank is to make money and exit without going to jail.”
Might be the most succinct quote on what Wall Street does that I’ve ever read.
Applies to politics as well.
Most conversation these days appears to focus on the final destination, as in interest rates. My takeaway from reading H for quite awhile is that the rate of travel is every bit as important. It appears that Powell is hell bent on getting to his approximately 2% target as quickly as possible and therein lies a big problem for financial markets.
Great article, great commentary. There are many secret societies in America, and finance is one of them. I am more interested in knowing what is, and maybe even what will be, than I am in exhausting arguments about what should be with folks who don’t know what they don’t know…
How do you pronounce r**?
Every’s last sentence got my attention.
“ The post-80s experiment of one central bank rate to allocate capital where markets most want it to go is as much as an aberration to long-run norms as free trade is to the mercantilism that preceded it, and will likely succeed it.”
Math guys and economists tend to say R* is r-star and R** is r-double star
Every’s grasp of history is routinely / reliably impressive, but what stood out about his critique here is the craftsmanship of the satire, and the hilarity of the subtle punchlines. “I don’t own any banks myself…” is the best example. To me (i.e., someone who loves subtle humor) that’s just pure gold.