The Myth of the Neutral Interest Rate
In his speech to the Economic Club of New York on November 28 2018, the Federal Reserve Board Chairman Jerome Powell said that the US central bank’s policy interest rate is just below the neutral rate. This prompted many commentators to suggest that a tighter interest rate stance of the Fed is likely coming to an end. At the end of October the fed funds rate target stood at 2.25%.
It is widely held 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 rate of interest.
The neutral rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is Fed policy makers successfully targeting the federal funds rate towards the neutral interest rate.
The Swedish economist Knut Wicksell articulated this framework of thinking in late 19th century, which has its origins in the 18 th century writings of British economist Henry Thornton.
The Neutral Interest Rate Framework
According to Wicksell, there is a certain rate of interest 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 variance between the money market interest rate and the neutral rate.
If the money market rate falls below the neutral 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 money market rate increases above the neutral 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 money market rate is in line with the neutral 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 rate which sets in motion changes in the money supply, which in turn disturb the general price level. Consequently, it is the role of the central authority to bring 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 rate. Thus if the market interest rate is above the neutral rate then the policy stance is tight. Conversely, if the market rate is below the neutral rate then the policy stance is loose.
Can We Know What the Neutral Rate Is?
In the mainstream framework, the neutral interest rate established at the point of the intersection of supply and demand curves.
The law of supply and demand as presented by mainstream economics does not however 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 originate 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."1
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 can one 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 interest rate, while a falling price level would signal that the interest rate must be lowered.2
Banks should adjust the market interest rate in the same direction as movements in the price level. Note that this procedure followed today by all central banks. Thus in response to increases in the price indexes above an accepted figure, the Fed raises the federal funds rate target.
Conversely, when the 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 the gap between the money market interest rate and the neutral rate is closed the central bank must at all times ensure that a gap does not emerge. In the Wicksellian framework, 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 rate target to the neutral rate level then this must mean that the economy is perfectly balanced.
Despite the fact that the neutral interest rate cannot be observed modern economists are of the view that it can be estimated by various indirect means. For instance one can establish what it is simply 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 can 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.3However, does all of this make much sense?4
What the Fed is trying to establish is a level of interest rate that corresponds to the conditions of the free market.
Obviously, this is in contradiction to the free market. 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 imaginary equilibrium.
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 an 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.
Why the Knowledge of the Level of the Neutral Rate Wouldn't Help the Fed Achieve Stability
Now, even if the Fed were to know the level of the neutral rate it could not achieve economic stability. The reason being that the Fed would have to pursue active monetary policies to maintain the neutral rate target.
This act however, will lead to boom-bust cycles and economic instability. Hence, there cannot be such thing as the neutral interest rate policy, which will result in economic and price stability.
Rather than targeting the money market interest rate towards the unknown neutral rate by means of monetary tampering, which leads to more instability, a better alternative is to leave the economy alone. In a free market economy without a central bank, no one would be conducting any kind of monetary policies.
In the absence of central bank monetary policies, which enrich some individuals at the expense of other individuals, interest rates that emerge will be truly neutral.
In a free market, no one then would be required to establish whether the interest rate is above or below some kind imaginary equilibrium.
- 1. Ludwig von Mises, Human Action chapter 16(2), Valuation and Appraisement, p 333.
- 2. 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.
- 3. Thomas Laubach and John C Williams, “Measuring the Natural Rate of Interest”. Board of Governors of the Federal Reserve System, November 2001.
- 4. John C. Williams, “The Natural Rate of Interest”, FRBSF Economic Letter October 31,2003.