Using The "Natural Interest Rate" In Setting Monetary Policy Is An Impossible Dream

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"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist."
–John M. Keynes1

It is held by many commentators that the Fed’s monetary policy, which is aimed at achieving price stability, is the key factor for attaining stable economic growth.

It is also held that what prevents the attainment of price stability is the fluctuations of the federal funds rate around the neutral interest rate, also known as the natural interest rate.

The natural interest rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required, then, is that the Fed successfully steer the federal funds rate toward the natural interest rate.

It is held that once the Fed brings the federal funds rate in line with the natural interest rate, price stability and economic stability are likely to emerge.

Note that this framework has its origins in the eighteenth-century writings of the British economist Henry Thornton. The Swedish economist Knut Wicksell further articulated this framework of thinking in the late nineteenth century.2

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 Wicksellian writings.

Now, if what we are suggesting is valid, obviously, then, what is required to understand the rationale of central banks actions is the writings of Knut Wicksell.

Knut Wicksell’s Framework for Price Stability

The heart of Wicksell’s framework is the natural interest rate, which Wicksell defined as,

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.3

Hence, according to Wicksell, the natural interest rate is the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.4

In his framework, Wicksell makes a clear distinction between the interest rate that is formed in the financial market and the interest rate that is established in the market without money. According to Wicksell the natural interest rate is formed by real factors without money.

On this Wicksell wrote,

Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.5

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