Today the Wall Street Journal published a letter to the editor written by Mark Thornton on the Fed’s basic misunderstanding of “natural” interest rates.
Dr. Thornton writes:
Federal Reserve officials are right to suggest that the so-called “natural” rate is important (“Fed Struggles With Long-Term Policy,” U.S. News, June 13). It is critical to understanding the business cycle. Economist Knut Wicksell pioneered the idea that the natural rate of interest stabilized the economy and determined its growth path. The natural rate is achieved or approximated by allowing market forces to exclusively determine interest rates. Economist Ludwig von Mises later showed that tinkering with interest rates causes modern business cycles. F.A. Hayek was awarded the Nobel Prize in 1974 for his elaborations on Mises’ approach, which is now referred to as the “Austrian Business Cycle Theory.”
Federal Reserve officials believe that the natural rate of interest is very low and could remain so for a very long period. However, if they considered that they have enormously expanded their own balance sheet and that, world-wide, central banks are engaged in a currency war and are suppressing interest rates, they might think otherwise. What would interest rates be if the Fed disgorged its holdings of mortgage-backed securities? What would they be if it started selling off holdings of U.S. government bonds? What if other central banks did likewise?
The Fed cannot “see” the natural rate of interest, but it is right before its eyes. You can achieve the natural rate by simply not increasing the money supply and withdrawing from interest-rate manipulation altogether.
Ludwig Von Mises Institute