The New Financial Stability Star the Fed Needs to Navigate By

(Bloomberg) -- Here’s another star for Federal Reserve Chairman Jerome Powell to chart as he maps out monetary policy: the newly christened ‘Fast-star.’

Though not part of the traditional economic canon, it’s the interest rate that’s consistent with ensuring financial stability, letters from which led us at Bloomberg to dub it the Fast-star. A rate too far below that level leads to excesses in the financial system in the form of asset bubbles and extreme leverage. A setting much above it stifles risk-taking and obliterates the “animal spirits” that drive economic growth.

The trouble is that Fast-star may be much higher than another star that’s a fixture in the economic firmament and that was referenced by Powell last week. R-star is the “neutral” interest rate that neither spurs nor restricts growth, the rate that stabilizes the economy once it’s achieved full employment and price stability. And it’s a rate that’s been falling in recent years.

There’s a “possibility that the interest rate/balance sheet policy stance that delivers on the dual mandate of employment and inflation may not necessarily be consistent with financial stability,” Allianz SE chief economic adviser Mohamed El-Erian wrote in an Aug. 27 article for Bloomberg.

You don’t have to go back too far to see how much difficulty that can cause. In the mid-2000’s, the Fed methodically raised interest rates to keep the economy on an even keel and inflation in check, using R-star as its lodestone.

But the rate increases weren’t nearly big enough to prevent a property bubble and a huge build-up in debt, especially given the largely hands-off approach of regulators at the time. Those excesses finally unwound in the deepest recession since the Great Depression.

Objectives Achieved

The risk is that the same sort of dynamic could be developing again. After years of running a loose monetary policy, the Fed is finally closing in on its twin objectives of maximum sustainable unemployment and 2 percent inflation. But that stance has also helped push U.S. stock and corporate bond prices to levels that central bank officials describe as “elevated.”

In his Aug. 24 speech at the Fed’s annual symposium in Jackson Hole, Wyoming, Powell discussed a number of “stars” that policy makers can use to try to navigate the ups and downs of the economy, while stressing the uncertainties surrounding them. He also used the speech to reaffirm the Fed’s current strategy of gradually raising interest rates.

Besides R-star, Powell pointed to U-star (the so-called natural rate of unemployment) and Pi-star (the inflation objective).

It’s no surprise he didn’t mention Fast-star. After all, it’s not yet found in the economic textbooks.

But Powell appeared to allude to its possible existence by linking financial stability to interest rate policy.

“In the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation,” he said. “Thus, risk-management suggests looking beyond inflation for signs of excesses.”

Summers’ Theory

Brevan Howard chief U.S. economist Jason Cummins was more explicit during an Institute of International Finance panel discussion earlier this year.

What if the interest rate “that equilibrates the real economy is different and much lower than the” one that equilibrates the financial economy, he asked. “You have to choose maybe one or maybe some combination of the two.”

The concept of Fast-star is also implicit in the secular stagnation theory espoused by former Treasury Secretary Lawrence Summers. The Harvard University professor argues that an excess supply of savings has depressed the level of R-star so much that it’s difficult for the Fed to hit it without also generating financial excesses.

“This issue is critical” for Powell and the Fed, El-Erian said in an email.

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Jeff Kearns

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