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Contrary to What Some Economists Claim, the Fed Can’t Give the Economy a “Neutral” Rate of Interest

Posted by M. C. on May 11, 2022

The idea of the neutral interest rate is unrealistic. The Fed attempts to establish an interest rate that corresponds to the conditions of the free market. Obviously, this is in contradiction to the free market, since in a free market there is no central bank setting the interest rate.

Given the impossible goal that the Fed tries to reach, we do not expect Fed policy makers to become wise and all knowing with regard to the correct level of interest rates. A better alternative is to leave the economy alone.

https://mises.org/wire/contrary-what-some-economists-claim-fed-cant-give-economy-neutral-rate-interest

Frank Shostak

On April 19, 2022, at the Economic Club in New York, the Chicago Federal Reserve Bank president Charles Evans said the Fed is likely to lift by year end its federal funds rate target range close to the neutral range of between 2.25 to 2.50 percent. Furthermore, on April 21, 2022, Fed chairman Jerome Powell corroborated this by stating that the Fed wants to raise its benchmark rate to the neutral level.

By popular thinking, the neutral rate is one that is consistent with stable prices and a balanced economy. Hence, in order to attain economic and price stability, Fed policy makers should navigate the federal funds rate toward the neutral rate range. The Swedish economist Knut Wicksell in the late nineteenth century articulated this framework of thinking, which has its origins in the eighteenth-century writings of the British economist Henry Thornton.

One can assume that the current framework of central bank operations throughout the world is based to a large degree on Wicksell’s writings, which means the key to comprehending the rationale of central banks actions is understanding the writings of Knut Wicksell.

The Neutral Interest Rate Framework

According to Wicksell the neutral rate is (Wicksell labels the neutral rate as the natural rate):

A certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.

In this way of thinking, the neutral rate of interest is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.1 Wicksell makes a clear distinction between the interest rate that is determined in financial markets and the neutral interest rate that is set without money. While the interest rate in financial markets is determined by demand and supply for money, the neutral interest rate is set by real factors. Thus, he wrote

Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.

According to the neutral rate framework, the main source of economic instability is because the money market interest rate is not in line with the neutral rate. In the Wicksell’s framework, money only affects the price level. The effect of money on the price level is however not direct, as it operates via the gap between the money market interest rate and the neutral rate. The mechanism works as following: if the 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 market rate rises 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 (on this topic, see this Fed working paper). Whenever the market rate is in line with the neutral rate, the economy is in a state of equilibrium and there is neither upward nor downward pressures on the price level.

According to Wicksell:

If it were possible to ascertain and specify the current value of the natural rate, it would be seen that any deviation of the actual money rate from this natural rate is connected with rising or falling prices according as the deviation is downward or upward.

Wicksell held that since the supply of real capital is limited while the supply of money can be regarded as elastic, there is no reason to assume that the money market interest rate would normally agree with the neutral real rate.2 Furthermore, Wicksell maintained that to establish whether monetary policy is tight or loose, it is not enough to pay attention to the level of money market interest rates, but rather one needs to contrast 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. Thus, according to Wicksell, whenever the money market rate is matched with the neutral rate the economy is in a state of equilibrium and there are neither upward nor downward pressure on the price level. 

Can Real Interest Rates Be Identified?

See the rest here

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