Eurasia Review: The Neutral Interest Rate: The Fed’s Impossible Goal – OpEd

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By Frank Shostak*

It is widely accepted that by
means of suitable monetary policies the US central bank can navigate the
economy towards a growth path of economic stability and prosperity. The
key ingredient in achieving this is price stability. Most experts are
of the view that what prevents the attainment of price stability are the
fluctuations of the federal funds rate around the neutral interest
rate.

The neutral interest rate, it is held, is one that is consistent with
stable prices and a balanced economy. What is required is for Fed
policy makers to successfully target the federal funds rate towards the
neutral interest rate.

This framework of thinking, which has its origins in the 18th century writings of British economist Henry Thornton, was articulated in late 19th century by the Swedish economist Knut Wicksell.1

The Neutral Interest Rate Framework

According to Wicksell, there is a certain interest rate on loans,
which is neutral in respect to commodity prices, and tend neither to
raise nor to lower them. According to this view, the main source of
economic instability is the variability in the gap between the money
market interest rate and the neutral interest rate.

Note that in this framework of thinking, the neutral interest rate is
established at the intersection of the supply and the demand curves.

If the market interest rate falls below the neutral interest rate,
investment will exceed saving, implying that aggregate demand will be
greater than aggregate supply. Assuming that the excess demand is
financed by the expansion in bank loans this leads to the creation of
new money, which in turn pushes the general level of prices up.

Conversely, if the market interest rate rises above the neutral
interest rate, savings will exceed investment, aggregate supply will
exceed aggregate demand, bank loans and the stock of money will
contract, and prices will fall. Hence whenever the market interest rate
is in line with the neutral interest rate, the economy is in a state of
equilibrium and there are neither upward nor downward pressures on the
price level.

Again, this theory posits that it is deviations in the money market
interest rate from the neutral interest rate, which sets in motion
changes in the money supply, which in turn disturbs the general price
level. Consequently, it is the role of the central authority to bring
the money market interest rates in line with the level of the neutral
interest rate.

According to this view, to establish whether monetary policy is tight
or loose, it is not enough to only focus on the level of money market
interest rates; rather one also needs to compare money market interest
rates with the neutral interest rate. If the market interest rate is
above the neutral interest rate then the policy stance is tight.
Conversely, if the market interest rate is below the neutral interest
rate then the policy stance is loose.

Can We Know What the Neutral Interest Rate Is?

The main problem here is that the neutral interest rate cannot be
observed. How can one tell whether the market interest rate is above or
below the neutral interest rate? The law of supply and demand as
presented by mainstream economics does not originate from the facts of
reality but rather from the imaginary construction of economists. None
of the figures that underpin the supply and demand curves originates
from the real world; they are purely imaginary.

According to Mises,

“It is important to realize that we do not have any knowledge or experience concerning the shape of such curves.”2

Yet, economists heatedly debate the various properties of these
unseen curves and their implications regarding government and central
bank policies.

Given that such curves do not exist and are, just useful for
illustration purposes this implies that it is not possible to establish
from non-existent curves the neutral interest rate.

Now, if the neutral interest rate cannot be observed how one can tell
whether the market interest rate is above or below the neutral rate?

Wicksell suggested that policy makers pay close attention to changes in the price level. A rising price level would call for an upward adjustment in the money market interest rate, while a falling price level would signal that the money market interest rate should be lowered.3

Banks should adjust the money market interest rate in the same
direction as movements in the price level. Note that this procedure is
followed today by all central banks.

An increase in the price indexes above a figure believed to be
associated with price stability causes Fed policy makers to raise the
Federal Funds interest rate target. Conversely, when price indexes are
growing at a pace considered as too low the Fed lowers the target.

According to the Wicksellian framework, in order to maintain price
and economic stability, once a gap between the money market interest
rate and the neutral interest rate is closed the central bank must at
all times ensure that the gap does not emerge; a monetary policy that
maintains the equality between the two rates becomes a factor of
stability.

Most experts hold that once the Fed has managed to bring the federal
funds interest rate target to the neutral interest rate level then this
must mean that the economy has reached a state of equilibrium.

Despite the fact that the neutral interest rate cannot be observed,
economists are of the view that it could be estimated by various
indirect means. For instance, one method to establish the neutral rate
has been suggested by averaging the value of the real fed funds rate
(fed funds rate minus price inflation) over a long period of time.

Some other economists hold that the neutral rate fluctuates over time and reject the notion that the neutral rate could be approximated by an average figure. In order to extract the unobservable moving neutral interest rate economists now employ sophisticated mathematical methods such as the Kalman filter.4 However, does all of this make much sense?5

Why the Fed Is Unlikely To Reach the Neutral Interest Rate Target

The whole idea of the neutral interest rate is unrealistic. What the
Fed is trying to establish is a level of interest rate that corresponds
to the conditions of the free market. Note that in order to establish
the neutral interest rate, which corresponds to the free market interest
rate, the Fed continuously tampers with interest rates and money
supply.

Obviously, this is in contradiction to the free market. Observe that a
free market interest rate implies that it originated in an unhampered
market. Also, note that the central bank tampering to establish the
neutral interest rate is a key factor behind the boom-bust cycles.

In a free market in the absence of central bank monetary policies,
the interest rates that emerge would be truly neutral. In a free market,
no one would be required to establish whether the interest rate is
above or below some kind of imaginary equilibrium.

Furthermore, equilibrium in the context of a conscious and purposeful
behavior has nothing to do with the imaginary equilibrium as depicted
by popular economics.

Equilibrium is established when individuals’ ends are met. When a
supplier is successful in selling his supply at a price that yields
profit he is said to have reached equilibrium. Similarly, consumers who
bought this supply have done so in order to meet their goals.

In a free market, in the absence of money creation, there is no need for a policy to restrain increases in the price level.

Given the impossible goal that the Fed tries to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct interest rate.

*About the author: Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Source: This article was published by the MISES Institute

  • 1. Robert L. Hetzel, “Henry Thornton: seminal monetary theorist and father of modern central bank.” Economic Review, July/August 1987, Federal Reserve Bank of Richmond. Also, see Murray N. Rothbard, Classical Economics, An Austrian Perspective on the History of Economic Thought volume 2, Edward Elgar, p 177.
  • 2. Ludwig von Mises, Human Action chapter 16(2), Valuation and Appraisement, p 333.
  • 3. Knut Wicksell, “Interest and Prices” A study of the causes regulating the value of money. Reprints of economic classics, Augustus M. Kelley, Bookseller, New York 1965 p189.
  • 4. Thomas Laubach and John C Williams, “Measuring the Natural Rate of Interest”. Board of Governors of the Federal Reserve System, November 2001.
  • 5. John C. Williams, “The Natural Rate of Interest”, FRBSF Economic Letter October 31,2003.

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