What Is This "Neutral" Interest Rate Touted By The Fed?
By Tyler Durden
Submitted by Mark Spitznagel via The Mises Institute,
There’s a lot of talk these days about the so-called “neutral” (or “natural” or “terminal”) interest rate projections of the Federal Reserve. In fact, their projection of this number is a key argument in their ongoing decision to keep rates at historically very-low levels for what has been an extended period of time. (Specifically, Federal Reserve officials have argued that the neutral interest rate has sharply declined in recent years, meaning that apparently ultra-low interest rates do not really signify easy monetary policy.)
What is this neutral rate? The neutral rate, it is argued, is simply the federal funds rate at which the economy is in equilibrium or balance. If the federal funds rate were at this mysterious neutral rate level, monetary policy would be neither loose nor tight, and the economy neither too hot nor too cold, but rather just chugging along at its long-run optimal potential. The underlying theory is that loose monetary policy — where the Fed’s policy rate is set below the neutral rate — can temporarily stimulate the economy, but only by causing price inflation that exceeds the Fed’s desired target (which, by the way, eventually causes overheating and a crash). On the other hand, if the Fed is too tight and sets the policy rate above the neutral rate, then unemployment creeps higher than desired and price inflation comes in below target.
In short, the neutral interest rate is one where the central bank is not itself distorting the economy. Monetary policy would really be nonexistent, as the Fed would not be altering the interest rate resulting from a free market discovery process between borrowers and savers. (This of course raises the question, why do central planners need to fabricate something that would naturally exist in their absence?) This is near where Yellen actually thinks we are these days, hence she sees little urgency in raising rates and thus lessening what, on the face of it, looks like a very loose current monetary policy.
The Theory of the Neutral or Natural Rate
Much of this neutral rate talk at the Fed is supposedly supported by the work of Swedish economist Knut Wicksell (1851–1926), who argued that the “natural” interest rate would express the exchange rate of present for future goods in a barter economy. If in practice the banks actually charged an interest rate below this natural rate, Wicksell argued that commodity prices would rise, whereas if the banks in practice charged an interest rate above the natural one, then commodity prices would fall. But that’s where Wicksell — often associated with the free-market Austrian school of economics — would cease to recognize his own ideas in current central bank thinking. Wicksell’s natural rate was a freely discovered market price in an economy, which reflected the implicit (real) rate of return on capital investments. For Wicksell, the natural interest rate was not a policy lever to be manipulated, in order to hit some employment or output goal. …read more
Source: What Is This "Neutral" Interest Rate Touted By The Fed?
