In her testimony to the Congressional Economic Committee on November 29, 2017, the Fed Chair Janet Yellen said that the neutral rate appears to be quite low by historical standards. From this, she concluded that the federal funds rate would not have to increase much to reach a neutral stance.
The neutral rate currently appears to be quite low by historical standards, implying that the federal funds rate would not have to rise much further to get to a neutral policy stance. If the neutral level rises somewhat over time, as most FOMC participants expect, additional gradual rate hikes would likely be appropriate over the next few years to sustain the economic expansion.
It is widely accepted that by means of suitable monetary policies the US central bank can navigate the economy toward 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 for Fed policymakers successfully targeting the federal funds rate toward the neutral interest rate.
This framework of thinking, which has its origins in the 18th century writings of British economist Henry Thornton,1 was articulated in the late 19th century by the Swedish economist Knut Wicksell.
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 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 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 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 rate of interest.
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?
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 rate? Wicksell suggested that policymakers pay close attention to changes in the price level. Thus, a rising price level would call for an upward adjustment in the money rate, while a falling price level would signal that the money interest rate must be lowered.2
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. Thus in response to increases in price indexes above an accepted figure the Fed raises the federal funds rate target.
Conversely, when price indexes are growing at a pace considered 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.
Why neutral rate cannot be established in hampered market?
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 rate, the Fed continuously tampers with interest rates and the 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.
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 policymakers to become wise and all-knowing with regard to the correct interest rate.