Who Knows the Neutral Rate of Interest? Not the Fed
On Wednesday May 10, Federal Reserve policy makers raised the federal funds rate target by 0.25% to 5%. This was the 16th increase in the target since June 2004 when it stood at 1%.
The statement issued by Fed Chairman Bernanke and his colleagues suggested they would now pause in the cycle of interest rate increases. They say that they must assess the implications on economic activity from the tight interest rate stance since June 2004. They hope to gain a clearer idea of the gap between the current federal funds rate and the neutral rate.
The Neutral Interest Rate Framework
It is their view that the neutral rate is that which accords with economic and price stability. The idea of the neutral rate emanates from writings of the Swedish economist Knut Wicksell. 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. 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.1
In other words, 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. (Note again that once the neutral rate is reached, that state of equilibrium is attained — implying that the economy is now well balanced and the price level is stable).
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 deviations in the money market interest rate from the neutral rate is what 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 pay attention to the level of money market interest rates; 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.
However, how is one to implement this framework? The main problem here is that the neutral interest rate can't 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. 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.
According to the Wicksellian framework, in order to maintain price stability 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. But is this possible? After all, maintaining this equality means that the central bank would have to manipulate the supply of money, which in turn will make things unstable.
In order to reach the neutral interest rate and hence price stability, the central bank must be forward-looking. The Fed must try to counter possible future movements in economic activity in order to reach the desired goal. Bernanke's present setting of interest rate is expected to counter various future factors that might prevent attainment of economic equilibrium.
There is always the possibility that Bernanke's assessment of the future course of the economy may turn out to be wrong. Even if the Bernanke's assessment of economic fundamentals proves to be accurate he could still be wrong on the monetary policy's time lag, which tends to shift.
For instance, our empirical analysis indicates that between 1963 to 1972 the average time lag between policy and effect stood at 10 months. Between 1973 to 1989 the lag was 12 months and from 1990 to present the lag is 15 months. Consequently, if Bernanke's assessment of the time lag turns out to be wrong, his interest rate setting may turn out to be not of an offsetting and stabilizing nature, but rather it may end in reinforcing economic swings — leading to more instability.
Consider the possibility that the monetary policy time lag has lengthened further and economic activity may still stay quite strong at least until the year end. In this case, by keeping the interest target unchanged at 5%, Bernanke runs the risk of strengthening the money supply rate of growth and thus setting the platform for higher inflationary expectations and higher price inflation in the future.
A stronger pace of economic activity whilst the federal funds rate target is relatively too low may give rise to a stronger demand for federal funds and this could force the Fed to lift the supply of money to defend the 5% federal funds rate target. Obviously, printing more money will only further destabilize the economy.
So far it seems that the federal funds rate target has been far too low relative to the pace of economic activity, which in turn forces the Fed to pump money at an increasing pace. After falling to 3.6% in November last year the yearly rate of growth of Fed Credit (the Federal Reserve balance sheet) climbed to 4.7% by the middle of May. Also, the growth momentum of money AMS has been in a visible increase since November last year. Year-on-year the rate of growth jumped from 1.2% to 3% in April.
Even if Bernanke and his colleagues are correct in their forecast and economic activity does slow down visibly in the months ahead there is no way of knowing whether the interest rate target is at the "right" level. There is the possibility that the federal funds rate target of 5% may turn out to be far too high. The Fed might keep the 5% federal funds rate target for a reasonable period of time before discovering that economic activity is falling rather fast. This in turn means that to defend the 5% federal funds rate target — as a result of a falling demand for federal funds due to weakening economic activity — the US central bank will be forced to withdraw money from the economy. By acting this way, the Fed runs the risk of draining liquidity, thus setting in motion an economic bust.
What the Fed is trying to achieve belongs to the world of a true free market economy. In a free market economy without a central bank, there would be no such thing as monetary policy. In the absence of central bank monetary policies, which enrich some individuals at the expense of other individuals, the interest rates that emerge would be truly neutral.
Also, in a free market no one would be required to establish whether the interest rate is above or below some kind of imaginary equilibrium. In a free market, with the absence of money creation, there is no need for a policy to restrain increases in the price level.
The whole idea of the neutral interest rate is unrealistic insofar as we have a Fed that continuously tampers with interest rates and money supply. Given the impossible goal that the Fed tries to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct interest rate.
Sooner rather than later, Bernanke's Fed policy will assume a reactive nature — the US central bank will respond to the data. The fact that the data tends to mirror the effect of past Fed's monetary policies means that the Fed is likely to respond to its own past actions.
The Fed tries to control the future but ends up only chasing its own tail, which leads to more confusion and uncertainty. All this could be further aggravated if Bernanke were to start setting targets for price inflation. As is always the case with centralized monetary planning, attempts to stabilize only bring about more destabilization.
Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He maintains weekly data on the AMS for subscribers through Man Financial, Australia. Send him mail and see his outstanding Mises.org Daily Articles Archive. Comment on the blog.
- 1. Knut Wicksell "Interest and Prices", Reprints of Economic Classics, New York, 1965, p. 102.