The Neutral Interest Rate: The Fed's Impossible Goal

It is widely accepted that by means of suitable monetary policies the US central bank can navigate the economy towards 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 interest rate.

The neutral interest rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is for Fed policy makers to successfully target the federal funds rate towards the neutral interest rate.

This framework of thinking, which has its origins in the 18th century writings of British economist Henry Thornton, was articulated in late 19th century by the Swedish economist Knut Wicksell.1

The Neutral Interest Rate Framework

According to Wicksell, there is a certain interest rate 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 variability in the gap between the money market interest rate and the neutral interest rate.

Note that in this framework of thinking, the neutral interest rate is established at the intersection of the supply and the demand curves.

If the market interest rate falls below the neutral interest 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 interest rate rises above the neutral interest 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 interest rate is in line with the neutral interest rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level.

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