A Fed-Induced “Neutral” Interest Rate Is a Contradiction in Terms
The New York Federal Reserve said on Tuesday, September 5, 2023, that the estimate for the neutral rate for Q2 has eased to 0.57 percent from 0.68 percent in Q1. Analysts typically translate that rate into a real-world setting by adding the neutral rate to the Fed’s 2 percent inflation target. The current reading suggests that a federal funds rate of around 2.5 percent would represent a neutral setting. Given that the Fed’s current target rate range is between 5.25 and 5.5 percent, this suggests that the interest rate policy remains very restrictive.
Based on this, it is quite likely that the Fed will loosen its interest rate stance ahead. This view is further reinforced by the massive increase in the ratio of the federal funds rate target to the neutral rate of 9.2 in Q2 this year from 0.2 in Q4 2021.
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 policymakers should navigate the federal funds rate toward the neutral rate range.
In the late nineteenth century, the Swedish economist Knut Wicksell articulated this framework, which has its origins in the eighteenth-century writings of the British economist Henry Thornton.
In fact, it is safe to suggest that the current framework of central bank operations throughout the world is based to a large degree on Wicksell’s writings. Now, if what we are suggesting is correct, then the obvious key to understanding the rationale of the actions of the central banks would be the writings of Knut Wicksell.
The Neutral Interest Rate Framework
According to Wicksell, the neutral rate 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. 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
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