(Bloomberg) -- The concept of R** presented in a paper at the New York Fed last week explains the issue facing the Federal Reserve as the market desperately tries to identify the ingredients for a pivot by the central bank.

The paper lays out:

  • R* = neutral rate for the REAL ECONOMY where supply=demand and there’s no inflation, our well-known Goldilocks scenario
  • R** = neutral rate for FINANCIAL STABILITY

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.

There are parallels to today’s backdrop: real yields have begun to climb, but core PCE is still too high and the labor market is still too strong. Yet financial stability at these rate levels is already becoming a problem: credit markets are freezing up, liquidity in Treasuries is deteriorating and dollar funding is stretched.

What does this widening gap between R* and R** mean? The financial system becomes unstable before the Fed is able to raise rates high enough to impact the labor market. In effect, the Fed will fail to rein in inflation before it’s forced to pause to tackle financial instability at home. This is the same situation that the Bank of England blew wide open last week with their emergency QE operation.

The next scenario for markets to grapple with: how to price a Fed that attempts to manage financial stability concerns (akin to the BOE’s liquidity operations) alongside rate hikes? Perhaps there’s another bout of risk assets plummeting and yields rising before we get to this point. But Friday’s non-farm payrolls could be a test; a hot print could push this narrative to the next level.

Take a look at the two previous Fed hiking cycles in 2004-2006 and in 2015-2019. Back then maybe the gap between R* and R** was small, so it didn’t matter. We saw cracks in the financial system appear around the same time as the general economy. And, lets be honest, we didn’t have a real inflation fight back then, so the urgency to raise rates into restrictive territory was absent. But with this new, wider gap between the two, could financial instability take center stage before the inflation fight even truly begins?

  • NOTE: Valerie Tytel writes for Bloomberg’s Markets Live. The observations are her own and not intended as investment advice. For more markets commentary, see the MLIV blog.

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