A new concept for financial stability
In this paper, Akinci et al. propose a complementary concept to r*, the “natural real interest rate,” which they call the “financial stability real interest rate, r**,” and which denotes 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 as it reflects a tension in terms of macroeconomic stabilization versus financial stability objectives.
They develop a model where some agents in the economy face a credit constraint that gives rise to debt-deflation or asset fire-sale dynamics. The credit constraint is only occasionally binding which implies that the economy is characterized by two states: when the constraint is not binding the economy is in a normal state or tranquil period; when the constraint binds the economy is in a crisis mode and a financial instability dynamic arises. The financial stability real interest rate is the interest rate that would be consistent with the constraint being binding. Their model:
- Can account for the fact that credit spreads display occasional spikes and captures the asymmetric relationship between credit spreads and economic activity;
- Shows that during a period of financial stress, r** stands below the natural real interest rate. This suggests that, under these circumstances, a policy rate that tracks the natural real interest rate leads to financial instability. Moreover, prolonged period of low real interest rate leads eventually to an increase in leverage of the banking sector and a lower level of the financial stability real interest rate.
Finally, they provide a measure for r** for the US economy: they show that the level of spreads is tightly associated with r**, and more precisely with the gap between r** and the real rate r, especially during episodes of financial stress.
The Financial (In)Stability Real Interest Rate, R**
Authors: Ozge Akinci, Gianluca Benigno, Marco Del Negro, Albert Queralto
From: Federal Reserve Bank of New York
